1. Inventories and the Cost of Goods Sold
Chapter 8
Chapter 8: Inventories and the Cost of Goods Sold

2. The Flow of Inventory Costs
BALANCE SHEET
Asset
Inventory
Purchase costs (or manufacturing costs)
as goods are sold
INCOME STATEMENT
Revenue
Cost of goods sold
Gross profit
Expenses
Net income
Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Inventory is reported as a current asset on the balance sheet.
Companies that sell inventory report the value of the inventory they have in stock at the end of the period as a current asset on the balance sheet.
Companies that sell inventory also have an additional expense item called Cost of Goods Sold on their income statements. The Cost of Goods Sold account represents the cost of the inventory sold during the period to help earn revenue.
Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of inventory sold, to cover all other expenses and a profit.

3. The Flow of Inventory Costs
In a perpetual inventory system, inventory entries parallel the flow of costs.
Remember that in a perpetual inventory system, inventory purchases are recorded by a debit to Inventory and a credit to Accounts Payable. This entry is similar to the entry made when any asset is purchased, such as a truck or land.
The cost entry on the sale date requires a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold.

4. Which Unit Did We Sell?
When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory.
On the sale date, a natural question arises: What is the unit cost of the inventory being sold? If all the inventory has the same unit cost, then this is not a difficult question to answer. However, in most cases, companies will have identical units of inventory in stock that have different unit costs.
Let’s see how to determine the cost of a unit of inventory sold.

5. Inventory Subsidiary Ledger
A separate subsidiary account is maintained for each item in inventory.
In this example related to portable generators, we have 5 units in inventory. Of those in stock, the company paid $1,000 each for 2 units and $1,200 each for 3 units. So, when we sell a unit, how is the cost determined for the unit that we sell?
There are four ways to determine the cost of inventory sold:
Specific Identification
First-in, First-out -- also known as FIFO
Last-in, First-out -- also known a LIFO, and
Average Cost

6. Data for an Illustration
The Bike Company (TBC)
Take a minute and review this chart for The Bike Company. This data will be used throughout the perpetual inventory examples to compare results.

7. Specific Identification
On August 14, TBC sold 20 bikes for $130 each.
Of the bikes sold 9 originally cost $91 and 11 cost $106.
When using the specific identification method, the specific cost of each unit that is sold is known. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders.
On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 9 bikes that cost $91 each and 11 bikes that cost $106 each.
The Cost of Goods Sold for August 14th is $1,985. After this sale, TBC has 5 units in inventory: 1 unit that costs $91 and 4 units that cost $106 each.
The Cost of Goods Sold for the August 14 sale is $1,985. This leaves 5 units, with a total cost of $515, in inventory:
1 unit that costs $91 and 4 units that cost $106 each.

8. Specific Identification
Retail (20 × $130)
Remember that in a perpetual inventory system, two entries are required to record a sale.
The first entry is to record the sale at retail and involves Cash or Accounts Receivable and Sales. In our example, we debit Cash for $2,600 (20 bikes at $130 each), and credit Sales for the same amount.
The second entry is to record Cost of Goods Sold at cost and remove the items sold from Inventory. In our case, we debit Cost of Goods Sold for $1,985 and credit Inventory for the same amount. We determined the Cost of Goods Sold amount on the previous screen. We will make a similar set of entries each time we have a sale.
Cost
A similar entry is made after each sale.

9. Specific Identification
Additional purchases were made on August 17 and 28.
Next, TBC makes a purchase on August 17th and another on August 28th. On August 31st, TBC sell 23 bikes: 1 that cost $91; 3 that cost $106 each; 15 that cost $115 each; and 4 that cost $119 each.
The Cost of Goods Sold for the August 31st sale is $2,610. After the August 31st sale, TBC has 12 units in inventory: 1 unit that costs $106; 5 units that cost $115 each; and 6 units that cost $119 each.

10. Specific Identification
Income Statement
COGS = $4,595
Using the specific identification method, TBC would report Cost of Goods Sold on their August income statement of $4,595 and they would report Ending Inventory on the balance sheet of $1,395.
Balance Sheet
Inventory = $1,395

11. The average cost per unit must be computed prior to each sale.
Average-Cost Method
On August 14, TBC sold 20 bikes for $130 each.
$2,500  25 = $100 avg. cost
When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.
On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes.
First, TBC needs to compute the average cost of the items in inventory. They do this by dividing the cost of goods available for sale of $2,500 by the total units in inventory of 25. The average cost per unit is $100.
Then, to determine the Cost of Goods Sold for August 14th, multiply the number of units sold by the average cost. This calculation determines that the Cost of Goods Sold for August 14th is $2,000.
After this sale, TBC has 5 units in inventory at an average cost of $100 each.
The average cost per unit must be computed prior to each sale.

12. Average-Cost Method $114 = $3,990  35
Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold.
Next, TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes.
To determine the average cost of the inventory items, TBC will divide the cost of goods available for sale of $3,990 by the total units in inventory of 35. The average cost per unit is $114.
The units on hand (35) is determined by taking the total units purchased (55) and subtracting the units sold (20). The Cost of Goods Sold for August 31st is $2,622.
After this sale, TBC has 12 units in inventory at an average cost of $114 each.
$114 = $3,990  35

13. Average-Cost Method Income Statement Balance Sheet Inventory = $1,368
COGS = $4,622
Using the weighted average method, TBC would report Cost of Goods Sold on their August income statement of $4,622. And they would report Ending Inventory on the balance sheet of $1,368.
Balance Sheet
Inventory = $1,368

14. First-In, First-Out Method (FIFO)
On August 14, TBC sold 20 bikes for $130 each.
The Cost of Goods Sold for the August 14 sale is $1,970, leaving 5 units, with a total cost of $530, in inventory.
When using the First-in, First-out (FIFO) method, the older costs are assigned to the units sold. That leaves the more recent costs to be used to value ending inventory.
On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes.
Using FIFO, first TBC assigns the cost of the 10 oldest inventory items purchased on August 1st at $91 each. Now, they need 10 more units, so they move down to the next purchase on August 3rd and include the cost of 10 units from this purchase at $106 each. The Cost of Goods Sold for August 14th is $1,970.
After this sale, TBC has 5 units in inventory at a cost of $106 each.

15. First-In, First-Out Method (FIFO)
Additional purchases were made on Aug. 17 and Aug. 28.
On August 31, an additional 23 units were sold.
TBC makes 2 purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes.
To determine the cost of goods sold on August 31st using FIFO, TBC takes the cost of the 5 remaining units from the August 3rd purchase at $106 each. Then, they move down to the next purchase on August 17th and take the cost of 18 units at $115 dollars each. The Cost of Goods Sold for August 31st is $2,600.
After the August 31st sale, TBC has 12 units in inventory: 2 units at $115 each and 10 units at $119 each.

16. First-In, First-Out Method (FIFO)
Income Statement
COGS = $4,570
Using the FIFO method, TBC would report Cost of Goods Sold on their August income statement of $4,570. They would report Ending Inventory on the balance sheet of $1,420.
Balance Sheet
Inventory = $1,420

17. Last-In, First-Out Method (LIFO)
On August 14, TBC sold 20 bikes for
$130 each.
When using the Last-in, First-out (LIFO) method, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes.
Using LIFO, first TBC assigns the cost of the 15 most recent inventory items purchased on August 3rd at $106 each. Now, they need 5 more units, so they move up to the next most recent purchase on August 1st and include the cost of 5 units from this purchase at $91 each. The Cost of Goods Sold for August 14th is $2,045.
After this sale, TBC has 5 units in inventory at a cost of $91 each.
The Cost of Goods Sold for the August 14 sale is $2,045, leaving 5 units, with a total cost of $455, in inventory.

18. Last-In, First-Out Method (LIFO)
Additional purchases were made on Aug. 17 and Aug On Aug. 31, an additional 23 units were sold.
TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes.
Using LIFO, TBC takes the cost of the 10 units from the most recent purchase on August 28th at $119 each. Then, they move up to the next most recent purchase on August 17th and take the cost of 13 units at $115 each. The Cost of Goods Sold for August 31st is $2,685.
After the August 31st sale, TBC has 12 units in inventory: 5 units at $91 each and 7 units at $115 each.

19. Last-In, First-Out Method (LIFO)
Income Statement
COGS = $4,730
Using LIFO, TBC would report Cost of Goods Sold of $4,730 on their August income statement. They would report Ending Inventory on the balance sheet of $1,260.
Balance Sheet
Inventory = $1,260

20. This slide provides a summary of some of the key differences among the four inventory valuation methods. Take a few minutes to review it.

21. The Principle of Consistency
Once a company has adopted a particular accounting method, it should follow that method consistently rather than switch methods from one year to the next.
The Principle of Consistency limits companies’ ability to switch accounting methods from period to period. The goal of this principle is to provide users with financial statements prepared using consistent accounting principles from one period to the next. This allows users to more easily make comparisons from period to period.
However, a company doesn’t have to use the same accounting principle forever. If a company has a good reason to change accounting principles, they can.

22. Taking a Physical Inventory
The primary reason for taking a physical inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, such as theft, spoilage, or breakage.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get records up to date to reflect what is actually on hand.
Remember from Chapter 6 that when a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.

23. LCM and Other Write-Downs of Inventory
Reduces the value of the inventory.
Obsolescence
Adjust inventory value to the lower of historical cost or current replacement cost (market).
Lower of Cost or Market (LCM)
Before reporting a value for Inventory on the balance sheet, companies consider any needed reductions for obsolescence. They also make sure to adjust the inventory value to the lower of cost or market.
Cost is determined using one of the methods just discussed: specific identification, FIFO, LIFO or average cost. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market follows the conservatism principle by not overstating the value of assets.

24. LCM and Other Write-Downs of Inventory
We can apply the lower-of-cost-or-market rule to individual inventory items, the categories of inventory items, or to the total inventory. At TBC we have two broad categories of inventory items – Bicycles and Bicycle accessories. You can see the inventory items that are in each category. Let’s begin by applying LCM to the individual inventory items.
When we apply the rule to individual items, we compare the cost and market of each item and select the lower. For example, for the Boy’s Bicycles total cost is $4,200 and total market value is $4,600, so we will select the lower amount, which is cost. We complete the process for all the other items in inventory. Inventory will be carried on the balance sheet at $14,054.
We have two major categories of inventory items at TBC. If we apply LCM by inventory categories, we will compare the total cost of Bicycles to total Market for Bicycles. Under this approach, inventory will be carried at $14,582.
Part IV
Finally, we can apply LCM to the entire inventory. Using this approach we compare total cost of $15,637, to total market of $14,582, and select the lower – market of $14,582. Inventory will be shown on the balance sheet at $14,582.

25. Goods In Transit
A sale should be recorded when title to the merchandise passes to the buyer.
F.O.B. shipping point  title passes to buyer at the point of shipment.
F.O.B. destination point  title passes to buyer at the point of destination.
FOB stands for Free On Board. FOB terms designate when titles pass and who pays transportation costs. If the shipping terms are Free On Board shipping point, that means ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost.
On the other hand, if the shipping terms are Free On Board destination, that means ownership transfers from the seller to buyer when the buyer receives the goods. It also means that the seller will pay the transportation cost.
If goods are shipped FOB Shipping Point and the goods are in transit at year end, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account.
Year End

26. Periodic Inventory Systems
In a periodic inventory system, inventory entries are as follows.
Recall that in a periodic inventory system, purchases of inventory are recorded with a debit to Purchases, not Inventory, and a credit to Accounts Payable.
Note that an entry is not made to inventory.

27. Periodic Inventory Systems
In a periodic inventory system, inventory entries are as follows.
Remember that in a periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale.
The cost entry that was made under the perpetual inventory system is not required because the periodic system does not attempt to keep the Inventory and Cost of Good Sold accounts up to date.
A periodic system does not maintain a cost of goods sold account so cost of goods sold must be calculated at the end of the period.

28. Information for the Following Inventory Examples
Now let’s see how to use the inventory valuation methods in a periodic inventory system.
Take a minute to review this chart for Computers, Incorporated. This data will be used throughout the periodic inventory examples and to compare the results at the end.

29. Specific Identification
Cost of Goods Sold
$9,725 - $6,400 = $3,325
First, let’s look at the specific identification method. Remember that in this method, the specific cost of each unit in inventory is known. At the end of the period, inventory is counted and cost is determined.
Computers, Incorporated, counted 1,200 mouse pads with a cost of $6,400.
This is enough information to determine Cost of Goods Sold for the year.
To calculate Cost of Goods Sold for the period, start with Goods Available for Sale of $9,725 dollars and subtract Ending Inventory, based on the physical count, of $6,400.

30. Average-Cost Method Avg. Cost $9,725  1,800 = $5.40278
Ending Inventory
Avg. Cost $ 1,200 = $6,483
Cost of Goods Sold
Avg. Cost $ 600 = $3,242
When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale for the period by the units available for sale for the period.
First, determine the average cost by taking Goods Available for Sale for the period and divide it by the number of units available for sale during the period. In this example, this calculation would be $9,725 divided by 1,800 units. The average cost is dollars.
To determine Ending Inventory, take the number of units in inventory and multiply by the average cost.
To determine Cost of Goods Sold, take the number of units sold and multiply by the average cost.

31. First-In, First-Out Method (FIFO)
Remember: Start with the Nov. 29 purchase and then add other purchases until you reach the number of units in ending inventory.
When using FIFO, assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.
For Computers, Incorporated, there are 1,200 units in Ending Inventory. Next, we need to determine the cost of these units.

32. First-In, First-Out Method (FIFO)
To determine the cost of the 1200 units remaining in inventory using FIFO, start with the most recent purchase and then add other purchases until 1,200 units are accounted for.
Start with the November 29th purchase of 150 units.
Add the units from the September 15th purchase, the June 20th purchase, the January 3rd purchase, and 400 units from the beginning inventory. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount.
Ending Inventory is $6,575.
The Cost of Goods Sold value for the 600 units sold is determined using the first costs in. Start with the beginning inventory and account for all 600 units. The Cost of Goods Sold is $3,150.
As a double check, when you add together the Ending Inventory and the Cost of Goods Sold, you should get the Cost of Goods Available for Sale.
Now, we have allocated a cost to all 1,200 units in ending inventory.

33. First-In, First-Out Method (FIFO)
Ending Inventory is $6,575.
The Cost of Goods Sold value for the 600 units sold is determined using the first costs in. Start with the beginning inventory and account for all 600 units. The Cost of Goods Sold is $3,150.
As a double check, when you add together the Ending Inventory and the Cost of Goods Sold, you should get the Cost of Goods Available for Sale.

34. First-In, First-Out Method (FIFO)
Completing the table summarizes the computations just made.
Here is the completed table using FIFO in a periodic inventory valuation system.

35. Last-In, First-Out Method (LIFO)
Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory.
When using LIFO, assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
For Computers, Incorporated, there are 1,200 units in Ending Inventory. To determine their cost using LIFO, start with the beginning inventory and then add other purchases until 1,200 units are accounted for.

36. Last-In, First-Out Method (LIFO)
Start with the beginning inventory of 1,000 units.
Add 200 units from the January 3rd purchase. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount.
Ending Inventory is $6,310.
The Cost of Goods Sold value for the 600 units sold is determined using the last costs in. Start with the November 29th purchase of 150 units. Then add the units from the September 15th purchase, the June 20th purchase, and 100 units from the January 3rd purchase. The Cost of Goods Sold is $3,415.
As a double check, when Ending Inventory and the Cost of Goods Sold are added together, they should equal the Cost of Goods Available for Sale.

37. Last-In, First-Out Method (LIFO)
Completing the table summarizes the computations just made.
Here is the completed table using LIFO in a periodic inventory valuation system.

38. International Financial Reporting Standards
International accounting standards prohibit the use of LIFO.
One major difference between U.S. accounting standards and International standards is that international standards do not recognize the LIFO method of accounting for the cost of inventory. International accounting standards prohibit the use of LIFO because it leads to outdated inventory numbers in the balance sheet. Only the first-in, first-out (FIFO) or weighted average cost methods are acceptable under international standards.
Another difference is in the application of lower-of-cost-or-market. Under U.S. generally accepted accounting standards, once an inventory is written down to a lower market value, recovery of that value before the inventory is sold is not permitted. Under international standards, however, the subsequent recovery of market value is treated as a reduction in cost of goods sold in the period of the recovery.

39. Importance of an Accurate Valuation of Inventory
Take a few minutes to review this chart. It shows the impact of inventory errors. For example, an understated Ending Inventory will result in an overstatement of Cost of Goods Sold, an understatement of Gross Profit, and an understatement of Net Income. On the Balance Sheet it will result in understated Ending Inventory and understated Owner’s Equity.
An error in the valuation of ending inventory affects not only the financial statements of the current year but also the income statement for the following year. The ending inventory in one year becomes the beginning inventory in the following year. An understatement of the beginning inventory results in an understatement of the cost of goods sold and, therefore, an overstatement of gross profit and net income in the following year. Notice that the original error has exactly the opposite effects on the net incomes of the two successive years. For this reason, inventory errors are said to be “self-correcting” over a two-year period.

40. The Gross Profit Method
Determine cost of goods available for sale.
Estimate cost of goods sold by multiplying the net sales by the cost ratio.
Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.
It is expensive and time consuming to take a physical count of inventory. As a result, in interim financial statements, most companies estimate ending inventory and cost of goods sold. Using this estimate helps avoid having to shut down production or close the doors to the business to do a physical count.
Let’s look at two methods used to estimate inventory for interim financial statements: the gross profit method and the retail method.
When using the gross profit method, follow these three steps. First, determine the Cost of Goods Available for Sale. This can be done using accounting data. Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. The cost ratio is based on past history of the company. Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory.

41. The Gross Profit Method
In March of 2011, Matrix Company’s inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix showed the following balances:
In March of 2011, Matrix’s inventory was destroyed by fire. Past history shows that Matrix’s normal Gross Profit ratio is 30% of Net Sales. Here are some other balances in Matrix’s accounting records: Sales were $31,500; Sales Returns were $1,500; Beginning Inventory was $12,000, and the Net Cost of Goods Purchased was $20,500. Let’s estimate the amount of the inventory lost in the fire.

42. The Gross Profit Method
× 70%
Step 1
Step 2
First, determine the Cost of Goods Available for Sale. This is calculated by adding Beginning Inventory and the Net Cost of Goods Purchased. The Cost of Goods Available for Sale is $32,500.
Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. To accomplish this, remember that Net Sales minus Cost of Goods Sold equals Gross Profit. Since the Gross Profit ratio is 30%, then the Cost of Goods Sold Ratio has to be 70%. Net Sales is calculated as Sales minus Sales Returns and Sales Discounts. In this problem, there are only Sales Returns. Seventy percent of $30,000 is $21,000, which is the estimate of the Cost of Goods Sold.
Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory, which in this case is $11,500.
Step 3

43. The Retail Method
The retail method of estimating inventory requires that management determine the value of ending inventory at retail prices.
In March of 2011, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s management collected the following information:
Now let’s look at how to use the Retail Method to estimate inventory using Matrix again. To use this method, management must determine the value of ending inventory at retail prices and then convert from retail prices to cost.
Now, let’s use the information provided for Matrix with the Retail Method to estimate Matrix’s inventory and cost of goods sold.

44. The Retail Method
Matrix would follow the steps below to estimate their ending inventory using the retail method.
First, we need to determine the cost ratio. This is calculated by dividing Goods Available for Sale at Cost by Goods Available for Sale at Retail. Matrix’s cost ratio is 65%.
Next, take Matrix’s ending inventory at retail of $22,000 and multiply it by the cost ratio to arrive at Estimated Ending Inventory at cost. For Matrix, this is $14,300.

45. (Beginning Inventory + Ending Inventory) ÷ 2
Financial Analysis
(Beginning Inventory + Ending Inventory) ÷ 2
Inventory Turnover measures how quickly a company sells its inventory. A ratio that is low compared to competitors suggests inefficient use of assets. To calculate this ratio, take Cost of Goods Sold and divide by Average Inventory.
The Average Number of Days to Sell Inventory ratio measures how many days on average it takes to sell inventory. It is calculated as Number of Days in the Year divided by Inventory Turnover.

46. (Beginning Receivables + Ending Receivables) ÷ 2
Financial Analysis
(Beginning Receivables + Ending Receivables) ÷ 2
Most businesses sell merchandise on account. Therefore, the sale of inventory often does not provide an immediate source of cash. To determine how quickly inventory is converted into cash, the number of days required to sell the inventory must be combined with the number of days required to collect the accounts receivable.
The receivables turnover is computed by dividing net sales by the average accounts receivable. The number of days required to collect these receivables then is determined by dividing 365 days by the turnover rate.

47. End of Chapter 8
End of chapter 8.