1. Inventories and Cost of Sales
Chapter 6
Chapter 6: Inventories and Cost of Sales

2. Determining Inventory ItemsC1
Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted.
Items requiring special attention include:
Goods in Transit
Goods Damaged or Obsolete
Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.
Goods on Consignment

3. Ownership passes to the buyer here.
Goods in Transit C1
Public Carrier
Seller
Buyer
FOB Shipping Point
Ownership passes to the buyer here.
Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for “Free On Board.” So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means the buyer will pay all transportation costs. In this case, the transportation costs will be added to the merchandise inventory account.
On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means the seller will pay the transportation costs.
FOB Destination Point
Public Carrier
Seller
Buyer

4. Thanks for selling my inventory in your store.
Goods on Consignment C1
Merchandise is included in the inventory of the consignor, the owner of the inventory.
Thanks for selling my inventory in your store.
Consignee
Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count.
Consignor

5. Goods Damaged or ObsoleteC1
Damaged or obsolete goods are not counted in inventory if they cannot be sold.
Damaged and obsolete goods are not counted in inventory if they cannot be sold. If these goods can be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is the sales price minus the cost of making the sale.
Cost should be reduced to net realizable value if they can be sold.

6. Determining Inventory Costs
Include all expenditures necessary to bring an item to a salable condition and location.
Invoice Cost
Minus Discounts and Allowances
Plus Insurance
The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition.
We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage, and import duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.
Plus Import Duties
Plus Storage
Plus Freight

7. Internal Controls and Taking a Physical Count
Most companies take a physical count of inventory at least once each year.
When the physical count does not match the Merchandise Inventory account, an adjustment must be made.
Good internal controls over count include:
Pre-numbered inventory tickets.
Counters have no inventory responsibility.
Counts confirm existence, amount, and quality of inventory item.
Second count is taken.
Manager confirms all items counted.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count may not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand. A company has adequate internal controls over the inventory count if, (1) it uses pre-numbered inventory tags, (2) inventory counters have no responsibility for inventory, (3) the count confirms the existence, amount, and quality of inventory items counted, (4) a second count of the inventory is made, and (5) a count supervisor confirms that all items in inventory have been counted.

8. Inventory Costing under a Perpetual System
Inventory affects . . .
Balance Sheet
Income Statement
The matching principle requires matching costs with sales.
Inventory transactions impact both the balance sheet and the income statement. Ending Inventory is reported as a current asset on the balance sheet and cost of goods sold is reported on the income statement.
The matching principle requires matching costs with sales.

9. Inventory Cost Flow Assumptions
Management decisions in accounting for inventory involve the following:
Items included in inventory and their costs.
Costing method (specific identification, FIFO, LIFO, or weighted average).
Inventory system (perpetual or periodic).
Use of market values or other estimates.
Management decisions in accounting for inventory involve the following:
Items included in inventory and their costs.
Costing method (specific identification, FIFO, LIFO, or weighted average).
Inventory system (perpetual or periodic).
Use of market values or other estimates.
Choices made concerning these four points affect the reported amounts for inventory, cost of goods sold, gross profit, income, current assets, and other accounts.
Four methods are commonly used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out; (3) last-in, first-out; and (4) weighted average. The graph on this slide shows the frequency in the use of these methods. Each method assumes a particular pattern for how costs flow through inventory. Each of these four methods is acceptable whether or not the actual physical flow of goods follows the cost flow assumption.

10. Inventory Cost Flow Assumptions
First-In, First-Out (FIFO)
Assumes costs flow in the order incurred.
Last-In, First-Out (LIFO)
Assumes costs flow in the reverse order incurred.
We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.
Weighted Average
Assumes costs flow at an average of the costs available.

11. Inventory Costing IllustrationP1
Here is information about the mountain bike inventory of Trekking for the month of August.
Take a minute and review this chart. We will use these data throughout our inventory examples so we can compare our results at the end. The inventory information is provided by Trekking, a sporting goods retailer. Data for the month of August includes: 1) beginning inventory; 2) purchases; and 3) sales.

12. Specific Identification
First, let’s look at the specific identification method. In this method, we know the specific cost of each unit that is sold. 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 14th, Trekking sold 8 bikes that cost $91 each and 12 bikes that cost $106. The total cost of goods sold on this date is $2,000. That leaves in inventory 2 bikes that cost $91 each and 3 bikes that cost $106 each.

13. Specific Identification
On August 31, Trekking sold 23 bikes with the cost per unit shown on your screen. The total cost of good sold on this date is $2,582.
Using the specific identification method, on August 31, there are 12 units in inventory at $1,408 (5 units at $115 each plus 7 units at $119 each).
Trekking would report Cost of Goods Sold on its August income statement of $4,582, and report Inventory on its balance sheet of $1,408.
Income Statement Cost of Goods Sold
Balance Sheet Inventory

14. Specific Identification
Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used.
Here are the entries to record the purchases and sales discussed previously (the colored boldface numbers are those impacted by the cost flow assumption). All purchases and sales are made on credit. The selling price of inventory on August 14 was $130 per unit sold and the selling price for the August 31 sale was $150 per unit sold.
All purchases and sales are made on credit. The selling price of inventory was as follows:
8/14 $ /

15. First-In, First-Out (FIFO)P1
Oldest Costs
Cost of Goods Sold
Recent Costs
Ending Inventory
The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.

16. First-In, First-Out (FIFO)P1
For the August 14 sale, the company first assigns the cost of the 10 oldest inventory items from beginning inventory on August 1 at $91 each. Now, we need 10 more units; so we move down to the next purchase on August 3 and include the cost of 10 units from this purchase at $106. The Cost of Goods Sold for August 14 is $1,970 ($910 plus $1,060). After this sale, there are 5 units left in inventory at a cost of $106 each.

17. First-In, First-Out (FIFO)P1
For the August 31 sale, the company first takes the cost of the 5 remaining units from the August 3 purchase at $106 each. Then, we move down to the next purchase on August 17 and take the cost of 18 units at $105 each. The Cost of Goods Sold for August 31 is $2,600. After the August 31 sale, there are 12 units in inventory: 2 units at $115 each and 10 units at $119 each.

18. First-In, First-Out (FIFO)P1
Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used.
Here are the entries to record the purchases and sales for the company. All purchases and sales are made on credit. The selling price of inventory on August 14 was $130 for each unit sold and $150 for each unit sold on August 31. The numbers in red font were determined using the FIFO method.
All purchases and sales are made on credit. The selling price of inventory was as follows:
8/14 $ /

19. Last-In, First-Out (LIFO)P1
Recent Costs
Cost of Goods Sold
Oldest Costs
Ending Inventory
The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.

20. Last-In, First-Out (LIFO)P1
For the August 14 sale, the company first assigns the cost of the 15 most recent inventory items purchased on August 3 at $106 each. Now, we need 5 more units, so move up to the beginning inventory on August 1, and include the cost of 5 units from this purchase at $91 each. The Cost of Goods Sold for August 14 is $2,045. After this sale, there are 5 units in inventory at a cost of $91 each.

21. Last-In, First-Out (LIFO)P1
For the August 31 sale, the company first takes the cost of the 10 units from the most recent purchase on August 28 at $119 each. Then, we move up to the next most recent purchase on August 17, and take the cost of 13 units at $115 each. The Cost of Goods Sold for August 31 is $2,685. After the August 31 sale, there are 12 units in inventory: 5 units at $91 each and 7 units at $115 each.

22. Last-In, First-Out (LIFO)P1
Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used.
Here are the entries to record the purchases and sales. All purchases and sales are made on credit. The selling price of inventory was $130 on August 14 and $150 on August 31. The numbers in red font were determined using LIFO.
All purchases and sales are made on credit. The selling price of inventory was as follows:
8/14 $ /

23. Weighted Average P1
When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.
Cost of Goods Available for Sale
Units on hand on the date of sale ÷
When using weighted average, we 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.

24. Weighted Average P1
First, we need to compute the weighted average cost of the items in inventory. We 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. The Cost of Goods Sold for August 14th is $2,000. After this sale, there are 5 units in inventory at an average cost of $100 each.

25. Weighted Average P1
The purchases on August 17 and August 28 result in a new weighted average cost used to determine cost of goods sold for the August 31 sale. To compute the new weighted average cost, the company will divide the cost of goods available for sale on August 31 of $3,990 by the total units in inventory of 35. The average cost per unit is $114.

26. Weighted Average P1
The Cost of Goods Sold for August 31 is $2,622. After this sale, there are 12 units in inventory at an average cost of $114 per unit.

27. Weighted Average P1
Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used.
Here are the entries to record the purchases and sales. All purchases and sales are made on credit. The selling price of inventory was $130 on August 14 and $150 on August 31. The numbers in red font were determined using the weighted average method.
All purchases and sales are made on credit. The selling price of inventory was as follows:
8/14 $ /

28. Financial Statement Effects of Costing Methods
Because prices change, inventory methods nearly always assign different cost amounts.
This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income. Specific identification provides the most accurate cost of goods sold amount. But, this method is very costly to use. In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO. As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income, and weighted average results in net income that falls in the middle of these two.

29. Financial Statement Effects of Costing Methods
Advantages of Methods
Weighted Average
First-In, First-Out
Last-In, First-Out
An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.
Smoothes out price changes.
Ending inventory approximates current replacement cost.
Better matches current costs in cost of goods sold with revenues.

30. Tax Effects of Costing Methods
The Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reporting taxable income.
If LIFO is used for tax purposes, the IRS requires it be used in financial statements.
Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, it must also use LIFO for financial reporting.

31. Consistency in Using Costing MethodsA1
The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods.
The consistency principle requires a company to use the same accounting methods from period to period so that financial statements are comparable across periods. Companies can change accounting methods occasionally only for good reasons.

32. Lower of Cost or Market P2
Inventory must be reported at market value when market is lower than cost.
Defined as current replacement cost (not sales price).
Consistent with the conservatism principle.
Can be applied three ways:
(1) separately to each individual item.
(2) to major categories of assets.
(3) to the whole inventory.
When we report inventory on the balance sheet, we report it at the lower of cost or market value. Cost is determined using one of the methods we just discussed: Specific identification, FIFO, LIFO, or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market value follows the conservatism principle by not overstating the value of assets.
We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole.

33. A motor sports retailer has the following items in inventory:
Lower of Cost or Market P2
A motor sports retailer has the following items in inventory:
Here is some information on inventory items of a motor sports retailer. Take a few minutes and review this information.

34. Lower of Cost or Market P2
Here is how to compute lower of cost or market for individual inventory items.
If we look at the individual items, we will select the lower of cost or market for each item in inventory. So, for the Roadster, we would select the market value of $140,000 because it is lower than cost of $160,000. Continuing down the chart, we would select the lower of cost or market for each item in inventory. At the end, we would use the total of $265,000 as the reported value of inventory.

35. Financial Statement Effects of Inventory Errors
Income Statement Effects
Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.

36. Financial Statement Effects of Inventory Errors
Balance Sheet Effects
Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated, which will result in an understatement of net income. An understatement of net income will result in an understatement of equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.

37. Inventory Turnover A3
Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available.
Inventory
Turnover =
Cost of goods sold
Avg. inventory
Inventory turnover is calculated as Cost of Goods Sold divided by Average Inventory. This ratio reveals how many times a company turns over (sells) its inventory during a period. If a company’s inventory greatly varies within a year, average inventory amounts can be computed from interim periods such as quarters or months. Users apply inventory turnover to help analyze short-term liquidity and to assess whether management is doing a good job controlling the amount of inventory available. A low ratio compared to that of competitors suggests inefficient use of assets. The company may be holding more inventory than it needs to support its sales volume. Similarly, a very high ratio compared to that of competitors suggests inventory might be too low. This can cause lost sales if customers must back-order merchandise. Inventory turnover has no simple rule except to say a high ratio is preferable provided inventory is adequate to meet demand.
Average Inventory =
(Beg. Inv. + End Inv.) ÷ 2

38. Days’ Sales in Inventory
Reveals how much inventory is available in terms of the number of days’ sales.
Days' Sales in
Inventory =
Ending Inventory
Cost of goods sold ×
365
Days’ Sales in Inventory is calculated as Ending Inventory divided by Cost of Goods Sold times To better interpret inventory turnover, many users measure the adequacy of inventory to meet sales demand. Days’ sales in inventory, also called days’ stock on hand, is a ratio that reveals how much inventory is available in terms of the number of days’ sales. It can be interpreted as the number of days one can sell from inventory if no new items are purchased. This ratio is often viewed as a measure of the buffer against out-of-stock inventory and is useful in evaluating liquidity of inventory.

39. Global View Items and Costs Making Up Inventory
Both U.S. GAAP and IFRS include in inventory all items that a company owns and holds for sale plus all cost expenditures necessary to bring those items to a salable condition and location.
Assigning Costs to Inventory
Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO, and Weighted Average. IFRS does not currently allow use of LIFO.
Both U.S. GAAP and IFRS include in inventory all items that a company owns and holds for sale plus all cost expenditures necessary to bring those items to a salable condition and location.
Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO, and Weighted Average. IFRS does not currently allow use of LIFO.
Both U.S. GAAP and IFRS require companies to write down inventory when its value falls below recorded cost. U.S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost.
Estimating Inventory Costs
Both U.S. GAAP and IFRS require companies to write down inventory when its value falls below recorded cost. U.S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost.

40. Appendix 6A: Inventory Costing under a Periodic System
LIFO computation of COGS and ending inventory under a periodic system.
Appendix 6A: Inventory Costing under a Periodic System
The basic aim of the periodic system and the perpetual system is the same: to assign costs to inventory and cost of goods sold. The same four methods are used to assign costs under both systems: specific identification; first-in, first-out; last-in, first-out; and weighted average. The results are the same for both a periodic and perpetual inventory system when using specific identification and FIFO.
We use information from Trekking as shown on this slide to illustrate how to assign costs using LIFO with a periodic system. The last-in, first-out (LIFO) method of assigning costs assumes that the most recent purchases are sold first. These more recent costs are charged to the goods sold, and the costs of the earliest purchases are assigned to inventory. LIFO results in costs of the most recent purchases being assigned to cost of goods sold, which means that LIFO comes close to matching current costs of goods sold with revenues. Use of LIFO for computing cost of inventory and cost of goods sold is shown in the middle graphic on this slide. This exhibit starts with computing $5,990 for 55 units available for sale—this is given to us at the start of this appendix. Applying LIFO, we know that the 12 units in ending inventory will be reported at the cost of the earliest 12 purchases. Reviewing the earliest purchases in order, we assign costs to the 12 bikes in ending inventory as follows: $91 cost to 10 bikes and $106 cost to 2 bikes. This yields 12 bikes costing $1,122 in ending inventory. We then subtract this $1,122 in ending inventory from $5,990 in cost of goods available to get $4,868 in cost of goods sold.
When LIFO is used with the periodic system, cost of goods sold is assigned costs from the most recent purchases for the period. With a perpetual system, cost of goods sold is assigned costs from the most recent purchases at the point of each sale. The purchases and sales entries are illustrated on this slide (the colored boldface numbers are those affected by the cost flow assumption).

41. Appendix 6B: Inventory Estimation Methods
Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical count impossible.
Retail Inventory Method
Gross Profit Method
Appendix 6B: Inventory Estimation Methods
Inventory sometimes requires estimation for two reasons. First, companies often require interim statements (financial statements prepared for periods of less than one year), but they only annually take a physical count of inventory. Second, companies may require an inventory estimate if some casualty such as fire or flood makes taking a physical count impossible. Estimates are usually only required for companies that use the periodic system. Companies using a perpetual system would presumably have updated inventory data. This slide summarizes two methods to estimate inventory: the retail inventory method and the gross profit method.

42. End of Chapter 6
End of Chapter 6.