Inventories and the Cost

of Goods Sold
Chapter 8

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin

Copyright 2012 The McGraw-Hill Companies,8-1

The Flow of Inventory

Costs
BALANCE SHEET

Purchase costs (or

manufacturing
costs)

Asset
Inventory
INCOME STATEMENT

as goods
are sold

Revenue
Cost of goods sold
Gross profit
Expenses
Net income
8-2

The Flow of Inventory

Costs

In a perpetual inventory system, inventory

entries parallel the flow of costs.
GENERAL JOURNAL
Date

Account Titles and Explanation

P
R Debit

Credit

Entry on Purchase Date

Inventory

$$$$

Accounts Payable

$$$$

Entry on Sale Date

Cost of Goods Sold
Inventory

$$$$
$$$$
8-3

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.

8-4

Inventory Subsidiary
Ledger

AA separate
separate subsidiary
subsidiary account
account is
is
maintained
maintained for
for each
each item
item in
in inventory.
inventory.

8-5

Data for an Illustration

The Bike Company (TBC)

8-6

Specific Identification
On
OnAugust
August14,
14,TBC
TBCsold
sold20
20bikes
bikesfor
for $130
$130each.
each.
Of
Of the
thebikes
bikessold
sold 99originally
originallycost
cost $91
$91and
and
11
11cost
cost $106.
$106.

The
TheCost
Costof
ofGoods
GoodsSold
Soldfor
forthe
theAugust
August14
14sale
saleis
is$1,985.
$1,985.
This
Thisleaves
leaves55units,
units,with
withaatotal
totalcost
costof
of$515,
$515,in
ininventory:
inventory:
11unit
unitthat
thatcosts
costs$91
$91and
and44units
unitsthat
thatcost
cost$106
$106each.
each.
8-7

Specific Identification

Retail
Retail (20
(20 $130)
$130)
Cost
Cost
A
Asimilar
similar entry
entry is
is made
made after
after each
each sale.
sale.
8-8

Specific Identification
Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and28.
28.

8-9

Specific Identification

Income Statement
COGS = $4,595

Balance Sheet
Inventory = $1,395

8-10

Average-Cost Method
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.

The
Theaverage
averagecost
costper
per
unit
unitmust
mustbe
becomputed
computed
prior
priorto
toeach
eachsale.
sale.

$2,500
$2,500 25
25 == $100
$100avg.
avg. cost
cost
8-11

Average-Cost Method
Additional
Additional purchases
purchaseswere
were made
madeon
onAugust
August17
17and
and
August
August28.
28. On
OnAugust
August31,
31,an
anadditional
additional23
23units
units
were
weresold.
sold.

$114
$114 == $3,990
$3,990 35
35
8-12

Average-Cost Method

Income Statement
COGS = $4,622

Balance Sheet
Inventory = $1,368

8-13

First-In, First-Out Method

(FIFO)
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.

The
The Cost
Cost of
of Goods
Goods Sold
Sold for
for the
the August
August 14
14 sale
sale is
is $1,970,
$1,970,
leaving
leaving 55 units,
units, with
with aa total
total cost
cost of
of $530,
$530, in
in inventory.
inventory.
8-14

First-In, First-Out Method

(FIFO)

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAug.
Aug.17
17and
andAug.
Aug.28.
28.
On
OnAugust
August31,
31,an
anadditional
additional23
23units
unitswere
weresold.
sold.

8-15

First-In, First-Out Method

(FIFO)

Income Statement
COGS = $4,570

Balance Sheet
Inventory = $1,420

8-16

Last-In, First-Out Method

(LIFO)
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for
$130
$130 each.
each.

The
TheCost
Costof
ofGoods
GoodsSold
Soldfor
forthe
theAugust
August14
14sale
saleis
is$2,045,
$2,045,
leaving
leaving55units,
units,with
withaatotal
totalcost
costof
of$455,
$455,in
ininventory.
inventory.
8-17

Last-In, First-Out Method

(LIFO)
Additional purchases were made on Aug. 17 and Aug.

Additional purchases were made on Aug. 17 and Aug.

28.
28. On
On Aug.
Aug. 31,
31, an
an additional
additional 23
23 units
units were
were sold.
sold.

8-18

Last-In, First-Out Method

(LIFO)

Income Statement
COGS = $4,730

Balance Sheet
Inventory = $1,260

8-19

Valuation
Valuation
Method
Method
Specific
Specific
identification
identification

Average
Average cost
cost

First-in,
First-in, First-out
First-out
(FIFO)
(FIFO)

Last-in,
Last-in, First-out
First-out
(LIFO)
(LIFO)

Inventory
Inventory Valuation
Valuation Methods:
Methods: A
A Summary
Summary
Costs
Allocated
to:
Costs Allocated to:
Cost
of
Goods
Cost of Goods
Sold
Inventory
Comments
Sold
Inventory
Comments
Actual
Actual
Actual cost
cost of
of
Actual cost
cost of
of units
units Parallels
Parallels physical
physical flow
flow
the
units
sold
remaining
Logical
method
when
the units sold
remaining
Logical method when units
units
are
unique
are unique
May
May be
be misleading
misleading for
for
identical
units
identical units
Number
Number
Number of
of units
units
Number of
of units
units on
on Assigns
Assigns all
all units
units the
the same
same
sold
times
the
hand
times
the
average
unit
cost
sold times the
hand times the
average unit cost
average
unit
cost
average
unit
cost
Current
average unit cost average unit cost
Current costs
costs are
are averaged
averaged
in
with
older
costs
in with older costs
Cost
of
earliest
Cost
of
most
Cost
Cost of earliest
Cost of most
Cost of
of goods
goods sold
sold is
is based
based
purchases
recently
on
purchases on
on
recently
on older
older costs
costs
hand
prior
to
the
purchased
units
Inventory
hand prior to the purchased units
Inventory valued
valued at
at current
current
sale
costs
sale
costs
May
May overstate
overstate income
income during
during
periods
of
rising
prices;
periods of rising prices; may
may
increase
increase income
income taxes
taxes due
due
Cost
of
most
Cost
of
earliest
Cost
of
goods
sold
shown
Cost of most
Cost of earliest
Cost of goods sold shown at
at
recently
purchases
recent
prices
recently
purchases
recent prices
purchased
units
(assumed
still
in
Inventory
purchased units
(assumed still in
Inventory shown
shown at
at old
old (and
(and
inventory)
perhaps
inventory)
perhaps out
out of
of date)
date) costs
costs
Most
conservative
method
Most conservative method
during
during periods
periods of
of rising
rising
prices;
often
results
prices; often results in
in lower
lower
income
taxes
income taxes
2-20

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.
8-21

Taking a Physical
Inventory

The
The primary
primary reason
reason for
for taking
taking aa physical
physical
inventory
inventory is
is to
to adjust
adjust the
the perpetual
perpetual inventory
inventory
records
records for
for unrecorded
unrecorded shrinkage
shrinkage losses,
losses,
such
such as
as theft,
theft, spoilage,
spoilage, or
or breakage.
breakage.

8-22

LCM and Other Write-Downs

of Inventory
Obsolescence
Obsolescence

Lower
Lower of
of Cost
Cost
or
or Market
Market
(LCM)
(LCM)

Reduces
Reduces the
the value
value
of
of the
the inventory.
inventory.
Adjust
Adjust inventory
inventory
value
value to
to the
the lower
lower
of
of historical
historical cost
cost or
or
current
current
replacement
replacement cost
cost
(market).
(market).
8-23

LCM and Other Write-Downs

of Inventory

8-24

Goods In Transit
A
Asale
sale should
should be
be recorded
recorded when
when title
title to
to
the
the merchandise
merchandise passes
passes to
to the
the buyer.
buyer.
F.O.B.
F.O.B.
shipping
shipping
point
point title
title
passes
passes to
to
buyer
buyer at
at the
the
point
point of
of
shipment.
shipment.

Year
End

F.O.B.
F.O.B.
destination
destination
point
point title
title
passes
passes to
to
buyer
buyer at
at the
the
point
point of
of
destination.
destination.
8-25

Periodic Inventory
Systems

In a periodic inventory system, inventory

entries are as follows.

Note
Note that
that an
an entry
entry is
is not
not
made
made to
to inventory.
inventory.
8-26

Periodic Inventory
Systems

In a periodic inventory system, inventory

entries are as follows.

8-27

Information for the Following

Inventory Examples
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

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

Cost of
Goods Sold

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200

600

8-28

Specific Identification
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Date
Beginning
Inventory
1,000 $ 5.25
Purchases:
Jan. 3
300
5.30
June 20
150
5.60
Sept. 15
200Sold5.80
Cost
of
Goods
Cost
of
Goods
Sold5.90
Nov. 29
150
Goods
$9,725
$6,400
== $3,325
$9,725
$6,400
$3,325
Available
for Sale
1,800

--

Ending
Inventory
Cost of
Goods Sold

Total

$ 5,250.00
1,590.00
840.00
1,160.00
885.00

$ 9,725.00

1,200

$ 6,400.00

600

$ 3,325.00
8-29

Average-Cost Method
Avg.
Avg.Cost
Cost $9,725
$9,7251,800
1,800==
$5.40278
$5.40278
Ending
EndingInventory
Inventory
Avg.
Avg.Cost
Cost $5.40278
$5.402781,200
1,200==
$6,483
$6,483
Cost
Costof
ofGoods
GoodsSold
Sold
Avg.
Avg.Cost
Cost $5.40278
$5.40278600
600==
$3,242
$3,242

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

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200
1,200

$ 6,483.00
?

600

$ 3,242.00
?
8-30

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.

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

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200

600

?
8-31

First-In, First-Out Method

(FIFO)
Date

Jan. 3
June 20
Sept. 15
Nov. 29
Units

Beg. Inv. Purchases

1,000@$5.25
300@$5.30
150@$5.60
200@$5.80
150@$5.90

End. Inv.
400@$5.25
300@$5.30
150@$5.60
200@$5.80
150@$5.90
1,200
150

Cost of
Goods Sold
600@$5.25

600

Now, we have allocated a cost to

all 1,200 units in ending
inventory.

8-32

First-In, First-Out Method

(FIFO)
Date

Jan. 3
June 20
Sept. 15
Nov. 29
Units

Beg. Inv. Purchases

1,000@$5.25
300@$5.30
150@$5.60
200@$5.80
150@$5.90

Costs
Cost of Goods Available for Sale

End. Inv.

Cost of
Goods Sold
600@$5.25

400@$5.25
300@$5.30
150@$5.60
200@$5.80
150@$5.90
1,200
150

600

$6,575

$3,150
$9,725
8-33

First-In, First-Out Method

(FIFO)
Completing
the table
summarizes
the
computations
just made.

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

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200

$ 6,575.00

600

$ 3,150.00
8-34

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.

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

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200

600

?
8-35

Last-In, First-Out Method

(LIFO)
Date
Jan. 3
June 20
Sept. 15
Nov. 29
Units

Beg. Inv. Purchases End. Inv.

1,000@$5.25
1,000@$5.25
300@$5.30 200@$5.30

1,200
1,000

100@$5.30
150@$5.60
200@$5.80
150@$5.90
600
100

$6,310

$3,415

150@$5.60
200@$5.80
150@$5.90

Costs
Cost of Goods Available for Sale

Cost of
Goods Sold

$9,725
8-36

Last-In, First-Out Method

(LIFO)
Completing
the table
summarizes
the
computations
just made.

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

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000 $

5.25

$ 5,250.00

300
150
200
150

5.30
5.60
5.80
5.90

1,590.00
840.00
1,160.00
885.00

1,800

$ 9,725.00

1,200

$ 6,310.00

600

$ 3,415.00
8-37

International Financial
Reporting Standards

International
International
accounting
accounting
standards
standards
prohibit
prohibit the
the
use
use of
of LIFO.
LIFO.

8-38

Importance of an Accurate
Valuation of Inventory

8-39

The Gross Profit Method

1.
1. Determine
Determine cost
cost of
of
goods
goods available
available for
for
sale.
sale.
2.
2. Estimate
Estimate cost
cost of
of
goods
goods sold
sold by
by
multiplying
multiplying the
the net
net
sales
sales by
by the
the cost
cost
ratio.
ratio.
3.
3. Deduct
Deduct cost
cost of
of goods
goods
sold
sold from
from cost
cost of
of
goods
goods available
available for
for

8-40

The Gross Profit Method

In
In March
March of
of 2011,
2011, Matrix
Matrix Companys
Companys
inventory
inventory was
was destroyed
destroyed by
by fire.
fire.
Matrix
Matrix normal
normal gross
gross profit
profit ratio
ratio is
is 30%
30%
of
of net
net sales.
sales. At
At the
the time
time of
of the
the fire,
fire,
Matrix
Matrix showed
showed the
the following
following balances:
balances:
Sales
$$ 31,500
Sales
31,500
Sales
1,500
Salesreturns
returns
1,500
Beginning
12,000
Beginning Inventory
Inventory
12,000
Net
20,500
Net cost
cost of
of goods
goodspurchased
purchased
20,500

8-41

The Gross Profit Method

Step
1

Step
2

70%

Step
3

8-42

The Retail Method

The
The retail
retail method
method of
of estimating
estimating inventory
inventory
requires
requires that
that management
management determine
determine the
the
value
value of
of ending
ending inventory
inventory at
at retail
retail prices.
prices.
In
In March
March of
of 2011,
2011, Matrix
Matrix Companys
Companys inventory
inventory was
was
destroyed
destroyed by
by fire.
fire. At
At the
the time
time of
of the
the fire,
fire, Matrixs
Matrixs
management
management collected
collected the
the following
following information:
information:

8-43

The Retail Method

Matrix
Matrix would
would follow
follow the
the steps
steps below
below to
to estimate
estimate
their
their ending
ending inventory
inventory using
using the
the retail
retail method.
method.
Estimating Inventory
The Retail Method
a
b
c
d
e

Goods available for sale at cost

Goods available for sale at retail
Cost ratio [a b]
Physical count of ending inventory priced at retail
Estimated ending inventory at cost [ c d]

$ 32,500
50,000
65%
22,000
$ 14,300

8-44

Financial Analysis

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

8-45

Financial Analysis

(Beginning
(Beginning Receivables
Receivables ++ Ending
Ending Receivables)
Receivables) 22

8-46

End of Chapter 8

8-47