Reporting and

Interpreting
Cost of Goods
Sold and
Inventory
Chapter 7

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

7-2

Understanding the Business

Primary
Primary Goals
Goals of
of
Inventory
Inventory
Management
Management

Provide
Provide sufficient
sufficient
quantities
quantities of
of highhighquality
quality inventory.
inventory.

Minimize
Minimize the
the costs
costs of
of
carrying
carrying inventory.
inventory.

7-3

Learning Objectives
Apply
Apply the
the cost
cost principle
principle to
to identify
identify the
the amounts
amounts
that
that should
should be
be included
included in
in inventory
inventory and
and the
the
matching
matching principle
principle to
to determine
determine cost
cost of
of goods
goods
sold
sold for
for typical
typical retailers,
retailers, wholesalers,
wholesalers, and
and
manufacturers.
manufacturers.

7-4

Items Included in Inventory

Inventory

Tangible

Held for Sale

Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory

Used to
Produce Goods
or Services

7-5

Costs Included in Inventory Purchases

The cost principle requires that inventory
be recorded at the price paid or the
consideration given.

Invoice
Price

Freight

Inspection
Costs

Preparation
Costs

7-6

Flow of Inventory Costs

Merchandiser
Merchandise
Merchandise
Purchases
Purchases

Manufacturer
Raw
Raw
Materials
Materials
Direct
Direct
Labor
Labor
Factory
Factory
Overhead
Overhead

Merchandise
Merchandise
Inventory
Inventory

Raw
Raw Materials
Materials
Inventory
Inventory

Work
Work in
in Process
Process
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

Finished
Finished Goods
Goods
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

7-7

Nature of Cost of Goods Sold

Beginning
Beginning
Inventory
Inventory

Purchases
Purchases
for
for the
the Period
Period

Goods
Goods available
available
for
for Sale
Sale
Ending
Ending Inventory
Inventory
(Balance
(Balance Sheet)
Sheet)

Cost
Cost of
of Goods
Goods Sold
Sold
(Income
(Income Statement)
Statement)

Beginning
Beginning inventory
inventory ++ Purchases
Purchases == Goods
Goods Available
Available for
for Sale
Sale
Goods
Goods Available
Available for
for Sale
Sale Ending
Ending inventory
inventory == Cost
Cost of
of goods
goods sold
sold

7-8

Learning Objectives

Report
Report inventory
inventory and
and cost
cost of
of goods
goods sold
sold using
using
the
the four
four inventory
inventory costing
costing methods.
methods.

7-9

Inventory Costing Methods

Specific
Identification

FIFO

LIFO

Weighted
Average

7-10

Inventory Costing Methods

Total
Total Dollar
Dollar Amount
Amount of
of Goods
Goods
Available
Available for
for Sale
Sale
Inventory
Costing Method
Ending
Ending Inventory
Inventory

Cost
Cost of
of Goods
Goods Sold
Sold

7-11

Specific Identification

When
When units
units are
are
sold,
sold, the
the
specific
specific cost
cost
of
of the
the unit
unit sold
sold
is
is added
added to
to
cost
cost of
of goods
goods
sold.
sold.

7-12

Cost Flow Assumptions

The choice of an inventory

costing method is not based
on the physical flow of goods
on and off the shelves.

7-13

First-In, First-Out Method

Oldest
Oldest Costs
Costs

Cost
Cost of
of
Goods
Goods Sold
Sold

Recent
Recent Costs
Costs

Ending
Ending
Inventory
Inventory

7-14

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000

$ 5.25

$ 5,250.00

500
300
250
200

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

Remember:
The costs of
most recent
purchases are
in ending
inventory. Start
with 11/29 and
add units
purchased
until you reach
the number in
ending
inventory.

7-15

First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
200 @ $5.90
200 Units

Cost of Goods
Sold

Units

7-16

First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units

Cost of Goods
Sold

Units

$ 6,695 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.

7-17

First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units
$ 6,695 Cost

Cost of Goods
Sold
1,000 @ $ 5.25
50 @ 5.30

1,050 Units
$ 5,515 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,050
1,050 units
units sold.
sold.

7-18

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25
5.30
5.60
5.80
5.90

Total
$

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

$ 6,695.00

Cost of
Goods Sold

1,050

$ 5,515.00

Here is the
cost of
ending
inventory
and cost
of goods
sold using
FIFO.

7-19

Last-In, First-Out Method

Oldest
Oldest Costs
Costs

Ending
Ending
Inventory
Inventory

Recent
Recent Costs
Costs

Cost
Cost of
of
Goods
Goods Sold
Sold

7-20

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000

$ 5.25

$ 5,250.00

500
300
250
200

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

Remember:
The costs of the
oldest
purchases are
in ending
inventory. Start
with beginning
inventory and
add units
purchased until
you reach the
number in
ending
inventory.

7-21

Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,000 Units

Cost of Goods
Sold

Units

7-22

Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units

Cost of Goods
Sold

Units

$ 6,310 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.

7-23

Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units
$ 6,310 Cost

Cost of Goods
Sold
300
300
250
200
1,050

@ $ 5.30
@ 5.60
@ 5.80
@ 5.90
Units

$ 5,900 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,050
1,050 units
units sold.
sold.

7-24

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

6,310.00

Cost of
Goods Sold

1,050

5,900.00

Here is the
cost of
ending
inventory
and cost of
goods sold
using LIFO.

7-25

Average Cost Method

When
When aa unit
unit is
is sold,
sold, the
the
average
average cost
cost of
of each
each unit
unit in
in
inventory
inventory is
is assigned
assigned to
to cost
cost
of
of goods
goods sold.
sold.
Cost of Goods
Available for
Sale

Number of
Units
Available for
Sale

7-26

Average Cost Method

Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25
5.30
5.60
5.80
5.90

Total
$

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
Weighted Average Cost

2,250

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

$ 12,210.00

$ 12,210
= $5.42667
2,250

7-27

Average Cost Method

Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
Weighted Average Cost

$ 12,210
= $5.42667
2,250

2,250

$ 12,210.00

Ending
Inventory

1,200

6,512.00

1,200 $ 5.42667

Cost of
Goods Sold

1,050

5,698.00

1,050 $ 5.42667

7-28

Comparison of Methods
Computers, Inc.
Income Statement
For Year Ended December 31, 2006

Net sales
Cost of goods sold:
Merchandise inventory, beginning
Net purchases
Goods available for sale
Merchandise inventory, ending
Cost of goods sold
Gross profit
Operating expenses
Income before taxes
Income taxes expense (30%)*
Net income

FIFO
$ 25,000

LIFO
$ 25,000

Weighted
Average
$ 25,000

$
$
$
$
$

* Tax expense amounts were rounded.

5,250
6,960
12,210
6,695
5,515
19,485
750
18,735
5,621
13,114

$
$
$
$
$

5,250
6,960
12,210
6,310
5,900
19,100
750
18,350
5,505
12,845

$
$
$
$
$

5,250
6,960
12,210
6,512
5,698
19,302
750
18,552
5,566
12,986

7-29

Financial Statement Effects of Costing

Methods
Advantages
Advantages of
of Methods
Methods
First-In,
First-Out

Last-In,
First-Out

Weighted
Average

Ending
Ending inventory
inventory
approximates
approximates
current
current
replacement
replacement cost.
cost.

Better
Better matches
matches
current
current costs
costs in
in cost
cost
of
of goods
goods sold
sold with
with
revenues.
revenues.

Smoothes
Smoothes out
out
price
price changes.
changes.

7-30

Learning Objectives

Decide
Decide when
when the
the use
use of
of different
different inventory
inventory
costing
costing methods
methods is
is beneficial
beneficial to
to aa company.
company.

7-31

Managers Choice of Inventory Methods

Net
Net Income
Income Effects
Effects
Managers
Managers prefer
prefer to
to report
report
higher
higher earnings
earnings for
for their
their
companies.
companies.

Income
Income Tax
Tax Effects
Effects
Managers
Managers prefer
prefer to
to pay
pay
the
the least
least amount
amount of
of taxes
taxes
allowed
allowed by
by law
law as
as late
late as
as
possible.
possible.

7-32

Choosing Inventory Costing Methods

If . . .
LIFO for
taxes

LIFO
Conformity
Rule

Then . . .
LIFO for
books

7-33

Learning Objectives

Report
Report inventory
inventory at
at the
the lower
lower of
of cost
cost or
or market
market
(LCM).
(LCM).

7-34

Valuation at Lower of Cost or Market

Ending
Ending inventory
inventory is
is reported
reported at
at the
the
lower
lower of
of cost
cost or
or market
market (LCM)
(LCM)..
Replacement
Replacement Cost
Cost
The
The current
current purchase
purchase price
price
for
for identical
identical goods.
goods.
The company will recognize a holding loss in the
current period rather than the period in which the
item is sold.
This practice is conservative.

7-35

Valuation at Lower of Cost or Market

Item
Pentium chips
Disk drives

Quantity
1,000
400

Cost
$ 250
100

Replacement
Cost
$
200
110

LCM
$ 200
100

Total LCM
$ 200,000
40,000

7-36

Learning Objectives
Evaluate
Evaluate inventory
inventory management
management using
using the
the
inventory
inventory turnover
turnover ratio
ratio and
and the
the effects
effects of
of
inventory
inventory on
on cash
cash flows.
flows.

7-37

Inventory Turnover
Inventory
=
Turnover

Cost of Goods Sold

Average Inventory

Average
Average Inventory
Inventory is
is .. .. ..

(Beginning
(Beginning Inventory
Inventory ++ Ending
Ending Inventory)
Inventory) 22

This
This ratio
ratio reflects
reflects how
how many
many times
times
average
average inventory
inventory was
was produced
produced and
and
sold
sold during
during the
the period.
period. A
A higher
higher ratio
ratio
indicates
indicates that
that inventory
inventory moves
moves more
more
quickly
quickly thus
thus reducing
reducing storage
storage and
and
obsolescence
obsolescence costs.
costs.

7-38

Inventory and Cash Flows

Add Increase in Inventory

Decrease in Accounts
Payable

Cost of
Goods
Sold

Cash
Payment to
Suppliers
Decrease in Inventory
Increase in Accounts
Subtract
Payable

7-39

Learning Objectives

Compare
Compare companies
companies that
that use
use different
different
inventory
inventory costing
costing methods.
methods.

7-40

Inventory Methods and Financial Statement

Analysis
U.S. public companies using LIFO also report beginning
and ending inventory on a FIFO basis if the FIFO values
are materially different.
Beginning
Beginning inventory
inventoryFIFO
FIFO
-- Beginning
Beginning inventory
inventoryLIFO
LIFO
Beginning
Beginning LIFO
LIFO Reserve
Reserve
(Excess
(Excess of
of FIFO
FIFO over
over LIFO)
LIFO)

Ending
Ending inventory
inventoryFIFO
FIFO
-- Ending
Ending inventory
inventoryLIFO
LIFO
Ending
Ending LIFO
LIFO Reserve
Reserve
(Excess
(Excess of
of FIFO
FIFO over
over LIFO)
LIFO)

7-41

LIFO and International Comparisons

LIFO Permitted?
No

Yes

Singapore

China

Canada
Australia
Great Britain

7-42

Learning Objectives
Understand
Understand methods
methods for
for controlling
controlling and
and
keeping
keeping track
track of
of inventory
inventory and
and analyze
analyze the
the
effects
effects of
of inventory
inventory errors
errors on
on financial
financial
statements.
statements.

7-43

Internal Control of Inventory

Separation of inventory
accounting and physical
handling of inventory.

Storage in a manner that

protects from theft and
damage.

Limiting access to
authorized employees.

Maintaining perpetual
inventory records.

Comparing perpetual
records to periodic
physical counts.

7-44

Perpetual and Periodic Inventory Systems

Provides
Provides up-to-date
up-to-date
inventory
inventory records.
records.

Perpetual
Perpetual
System
System
Provides
Provides up-to-date
up-to-date
cost
cost of
of sales
sales records.
records.
In a periodic inventory system, ending inventory and cost of
goods sold are determined at the end of the accounting
period based on a physical count.

7-45

Perpetual and Periodic Inventory Systems

Inventory System
Periodic System
Carried over
Beginning Inventory
from prior period
Accumulated in
Add: Purchases
the Purchases
account
Measured at end
of period by
Less: Ending Inventory
physical
inventory count
Computed as a
residual amount
Cost of Goods Sold
at end of period
Item

Perpetual System
Carried over from
prior period
Accumulated in
the Inventory
account
Perpetual record
updated at every
sale
Measured at
every sale based
on perpetual
record

7-46

Errors in Measuring Ending Inventory

Errors in Measuring Inventory
Ending Inventory

Beginning Inventory

Overstated Understated Overstated Understated

Effect on Current Period's Balance Sheet
Ending Inventory
Retained Earnings

+
+

N/A

N/A

N/A

N/A

+
+

+
-

+
+
-

+
+

Effect on n Current Period's Income Statement

Goods Available for Sale
Cost of Goods Sold
Gross Profit
Net Income

7-47

Chapter Supplement A

LIFO
LIFO Liquidations
Liquidations

7-48

LIFO Liquidations
When a LIFO company sells more inventory than it
purchases or manufactures, items from beginning
inventory become part of cost of goods sold. This is
called a LIFO liquidation.
When inventory costs are rising,
these lower cost items in
beginning inventory produce a
higher gross profit, higher
taxable income, and higher
taxes when they are sold.

7-49

LIFO Liquidations
Companies must disclose the effects of LIFO
liquidations in the notes when they are material.

Many companies avoid LIFO

liquidations and the accompanying
increase in tax expense by
purchasing sufficient quantities of
inventory at year-end to ensure that
ending inventory quantities are
greater than or equal to beginning
inventory quantities.

7-50

Chapter Supplement B

Additional
Additional Issues
Issues in
in Measuring
Measuring
Purchases
Purchases

7-51

Purchase Returns and Allowances

Purchase returns and allowances are a reduction in
the cost of purchases associated with unsatisfactory
goods.
Returned goods require a
reduction in the cost of
inventory purchases and the
recording of a cash refund or a
reduction in the liability to the
vendor.

7-52

Purchase Discounts
A purchase discount is a cash discount received for
prompt payment of an account.

Terms
Time
Due

Discount Period

Credit Period

Full amount
less discount

Full amount due

Purchase or Sale

7-53

Purchase Discounts

2/10,n/30
Discount
Discount
Percent
Percent

Number
Number of
of
Days
Days
Discount
Discount Is
Is
Available
Available

Otherwise,
Otherwise,
Net
Net (or
(or All)
All)
Is
Is Due
Due

Credit
Credit
Period
Period

7-54

Purchase Discounts

Purchases paid for

within the discount
period reduce the
Inventory account for
the amount of the cash
discount received.

7-55

Chapter Supplement C

Comparison of Perpetual and

Periodic Inventory Systems

7-56

Perpetual Inventory System

Jan. 1
Apr. 14

Nov. 30

Dec. 31

Had beginning inventory of 800 units at a unit cost of

$50.
Purchased 1,100 units at a unit cost of $50.
Inventory
55,000
Accounts payable
55,000
Sold 1,300 units at a sales price of $83.
Accounts receivable
107,900
Sales revenue
107,900
Cost of goods sold
65,000
Inventory
65,000
Use cost of goods sold and inventory amounts.

7-57

Periodic Inventory System

7-58

End of Chapter 7