Financial Accounting - Chapter 5

Chapter 5
Inventories and Cost

of Goods Sold
2017 Cengage Learning. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
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Learning Objectives
LO1 Identify the forms of inventory held by different types of
businesses and the types of costs incurred.
LO2 Explain how wholesalers and retailers account for sales of
merchandise.
LO3 Show that you understand how wholesalers and retailers
account for cost of goods sold.
LO4 Use the gross profit ratio to analyze a companys ability to
cover its operating expenses and earn a profit.
LO5 Explain the relationship between the valuation of inventory
and the measurement of income.
LO6 Apply the inventory costing methods of specific
identification, weighted average, FIFO, and LIFO by using a
periodic system.
Learning Objectives (continued)
LO7 Analyze the effects of the different costing methods on
inventory, net income, income taxes, and cash flow.
LO8 Analyze the effects of an inventory error on various financial
statement items.
LO9 Apply the lower-of-cost-or-market rule to the valuation of
inventory.
LO10 Analyze the management of inventory.
LO11 Explain the effects that inventory transactions have on the
statement of cash flows.
LO12 Explain the differences in the accounting for periodic and
perpetual inventory systems and apply the inventory
costing methods using a perpetual system (Appendix).
Module 1 Sales, Cost of Goods Sold,
and Gross Profit
Inventory is an asset that is held for resale in the
normal course of business
Types of inventory costs incurred and the form
the inventory takes differs
The relationship between the companys sales
and the cost of those sales can be used to assess
the companys performance
2017 Cengage Learning. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as Module 1
Three Types of Manufacturing Costs
1. Direct materials: also called raw materials
Ingredients used in making a product
2. Direct labor: amounts paid to workers to
manufacture the product
3. Manufacturing overheads: all other costs that
are related to the manufacturing process but
cannot be directly matched to specific units of
output
Example: depreciation of building and salary of
supervisor
2017 Cengage Learning. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as Module 1: LO 1
Three Forms of Inventory
Direct materials orraw materials
Work in process: product is not finished
Finished goods: inventory that is complete and
ready for sale
Merchandise inventory for a retailer/wholesaler
Exhibit 5-1Relationships between
Types of Businesses and Inventory
Costs
Net Sales of Merchandise
Gross profit: Net sales less cost of goods sold
Sales revenue: representation of the inflow of
assets, either cash or accounts receivable, from
the sale of a product during the period
Net sales: Sales revenue less sales returns and
allowances and sales discounts
Exhibit 5-2Condensed Income
Statement for a Merchandiser
Sales Returns and Allowances
Sales returns and allowances: refunds to
customers or an allowance for spoiled or
damaged merchandise
Credit Terms and Sales Discounts
Credit terms: firms policy for granting credit
n/30: the net amount of the selling price is due
within 30 days of the date of the invoice
Net, 10 EOM: the net amount is due anytime
within ten days after the end of the month
1/10, n/30: the customer can deduct 1% from
the selling price if the bill is paid within ten days
Sales discounts: discounts given to customers
for early payment of their accounts
Cost of Goods Sold Model
Recognition of cost of goods sold as an expense
is an excellent example of matching principle
Sales revenue: inflow of assets, cash or accounts
receivable
Cost of goods sold: outflow of asset, inventory
Cost of goods available for sale

Beginning inventory + Cost of goods purchased
Cost of goods sold
Cost of goods available for sale Ending inventory
Exhibit 5-3Cost of Goods Sold
Section of the Income Statement
Exhibit 5-4Cost of Goods Sold
Model
Example 5-2Calculating Cost of
Goods Sold
Inventory Systems: Perpetual and
Periodic
Perpetual: inventory account is increased at the
time of each purchase and decreased at the
time of each sale
Periodic: inventory account is updated only at
the end of the period
Example 5-3Recording Cost of
Goods Sold in a Perpetual System
Assume that Daisys sells a pair of running shoes that costs the company $70
In addition to the entry to record the sale, Daisys would also record this
entry:
Cost of Goods Purchased
Purchases: temporary account to record
acquisitions of inventory
Purchase Discounts: cash discount that results
in a reduction of the cost to purchase
merchandise
Purchase Returns and Allowances: reductions
in the cost to purchase merchandise
Example 5-4Recording Purchases
in a Periodic System
Assume that Daisys buys shoes on account from Nike at a cost of $4,000
The journal entry to record the purchase is as follows:
Example 5-5Recording Purchase
Discounts in a Periodic System
Assume Daisys purchases merchandise on March 13 for $500 and takes
advantage of the discount for early payment
Record the purchase at the net amount, that is the estimated amount it
expects to pay: $500 ($500 0.01), or $495
The entry at the time of the purchase is as follows:
Example 5-5Recording Purchase
Discounts in a Periodic System
(continued)
Assume that the company does pay its account on March 23, within the
discount period
The following entry would be made:
Shipping Terms and Transportation
Costs
Cost principle: All costs necessary to prepare an
asset for its intended use should be included in
its cost
FOB: free on board
FOB destination point: seller pays for the cost of
shipping the merchandise to the buyer
FOB shipping point: buyer pays for the shipping
costs
Example 5-6Recording
Transportation-In in a Periodic
System
Assume that on delivery of a shipment of goods, Daisys pays an invoice for
$300 from Rocky Mountain Railroad
Terms of shipment are FOB shipping point
The entry on Daisys books follows:
The Gross Profit Ratio
Important measure of profitability
Indicates a companys ability to cover operating
expenses and earn a profit
Gross Profit
Gross Profit Ratio =
Net Sales
The Ratio Analysis Model
1. How much of the sales revenue is used for the
cost of the products, and thus, how much remains
to cover other expenses and to earn net income?
2. Gather the information about net sales and cost of
goods sold
3. Calculate the gross profit ratio
4. Compare the ratio with prior years and with
competitors
5. Interpret the ratiosshowing increase or decrease
Calculate the Ratio
The Business Decision Model
1. If you were an investor, would you buy stock in
a company?
2. Gather information from the financial
statements and other sources
3. Compare the company's gross profit ratio with
industry averages and look at trends
4. Buy stock or find an alternative use for the
money
5. Monitor the investment periodically
Module 2 Inventory Costing
Methods
Inventory costing methods are used to assign
costs to the products sold
Valuation of Inventory and the
Measurement of Income
Value assigned to inventory on balance sheet
determines the amount eventually recognized
as an expense on income statement
Incorrect ending inventory will affect cost of
goods sold and net income
Inventory Costs
Cost: price paid or consideration given to
acquire an asset
Includes expenditures directly or indirectly incurred in
bringing to its existing condition and location
Examples:
Freight costs incurred to bring inventory to the place
of business
Cost of insurance when inventory is in transit
Cost of storing inventory before it is ready to be sold
Taxes paidexcise and sales taxes
Inventory Costing Methods
with a Periodic System
Specific Identification Method
Weighted Average Cost Method
First-In, First-Out Method (FIFO)
Last-In, First-Out Method (LIFO)
Specific Identification Method
An inventory costing method that relies on matching unit costs
with the actual units sold
A problem with the specific identification method is that it
allows management to manipulate income
For example, management may selectively sell units with the lowest
possible unit cost to keep cost of goods sold down and net income up
Weighted Average Cost Method
An inventory costing method that assigns the
same unit cost to all units available for sale
during the period
Cost of Goods Available for Sale
Weighted Average Cost =
Units Available for Sale
Weighted Number of Units in

Ending inventory =
Average Cost Ending Inventory
Example 5-10Determining Ending
Inventory and Cost of Goods Sold
Using Weighted Average
(continued)
Ending inventory is found by multiplying the weighted average unit cost by
the number of units on hand:
Weighted Average Cost x Number of Units in Ending Inventory = Ending Inventory
$11.40 x 600 = $6,840
(continued)
Cost of goods sold can be calculated in one of two ways:
Weighted Average Cost x Number of Units Sold = Cost of Goods Sold

$11.40 x 900 = $10,260
or
First-In, First-Out Method (FIFO)
An inventory costing method that assigns the
most recent costs to ending inventory
Using FIFO
To calculate Russell Companys ending inventory using FIFO, we start with the
most recent inventory acquired and work backward as follows:
Using FIFO (continued)
Cost of goods sold can then be found as follows:
Using FIFO (continued)
Or because the FIFO method assumes that the first units purchased are the
first ones sold, cost of goods sold can be calculated by starting with the
beginning inventory and working forward as follows:
Last-In, First-Out Method (LIFO)
An inventory costing method that assigns earlier
(not recent) costs to ending inventory
Using LIFO
To calculate Russell Companys ending inventory using LIFO, we start with the
beginning inventory acquired and work forward as follows:
Using LIFO (continuing)
Cost of goods sold can then be found as follows:
Using LIFO (continuing)
Or because the LIFO method assumes that the last units purchased are the
first ones sold, cost of goods sold can be calculated by starting with the most
recent inventory acquired and working backward
Selecting an Inventory Costing
Method
The choice of an inventory method will impact
cost of goods sold and thus net income
A company should choose the method that
results in the most accurate measure of net
income for the period
Exhibit 5-5Income Statements for
the Inventory Costing Methods
Exhibit 5-5Income Statements for
the Inventory Costing Methods
(continued)
The weighted average method normally yields
results between LIFO and FIFO
The lower gross profit under LIFO results in
lower income before tax, which in turn leads to
lower taxes
Result of FIFO and LIFO during a
Period of Rising Prices
LIFO Issues
LIFO liquidation
Negative tax consequences
LIFO conformity rule
If LIFO is used on a tax return, it must also be used in
reporting income to stockholders
LIFO reserve
The excess of the value of a companys inventory
stated at FIFO over the value stated at LIFO
Costing Methods and Inventory
Profits
Replacement cost: the current cost of a unit of
inventory
Inventory profit: the portion of the gross profit
that results from holding inventory during a
period of rising prices
Inventory Valuation in Other
Countries
The valuation of inventory differs around the
world
GAAP in the United States allows LIFO
IASB strictly prohibits the use of LIFO
Survival of LIFO is not only a matter of

convergence with international standards
LIFO allows companies with rising inventory costs to
report lower income
Module 3 Other Inventory Issues
Inventory errors affect the financial statements.
The lower-of-cost-or market rule is applied to
value inventory
Inventory Errors
Mathematical errors
Physical count of inventory at year-end
Cutoff problemsin-transitat year-end
Exhibit 5-6Summary of the Effects
of Inventory Errors
Valuing Inventory at Lower of Cost
or Market
A conservative inventory valuation approach
Require that inventory be written down at the
end of the period if the market value of the
inventory is less than its cost
Can be applied to:
Entire inventory
Individual items
Groups of items
Valuing Inventory at Lower of Cost
or Market (continued)
Exhibit 5-7Gross Profit
Percentage Before and After Price
Change
Lower-of-Cost-or-Market under
International Standards
Required under both U.S. GAAP and IFRS
Difference:
U.S. GAAP
Define market value as replacement cost, subject to a
maximum and a minimum amount
New amount becomes basis for future adjustments
IFRS
Uses net realizable value with no upper or lower limits
Write-downs of inventory can be reversed in later periods
Module 4 Inventory Management
and Cash Flow Issues
The relationship between sales on the income
statement and inventory on the balance sheet is
used to assess how well a company is managing
its inventory
Inventory transactions affect cash flows
Inventory Turnover Ratio
Measures companys ability to sell its inventory
quickly
Number of times inventory is sold during a
period
Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory
Number of Days Sales in Inventory
Measures of how long it takes to sell inventory
Number of Days Sales Number of Days in the Period

=
in Inventory Inventory Turnover Ratio
The Ratio Analysis Model
1. How many times a year does a company turn
over its inventory?
2. Gather cost of goods sold from the income
statement and average inventory from balance
sheet at the end of the two most recent years
3. Calculate the inventory turnover ratio
4. Compare the ratio with other ratios
5. Interpret the ratiosmeasure of how long it
takes to sell inventory
Calculate the Ratio
The Business Decision Model
1. If you were an investor, would you buy stock in
the company?
2. Gather information from the financial
statements and other sources
3. Compare trends in inventory turnover ratios,
net income with industry averages
4. Buy stock or find an alternative
5. Monitor your decision periodically
Exhibit 5-8Inventories and the
Statement of Cash Flows
Exhibit 5-9Partial Consolidated
Exhibit 5-9Partial Consolidated
(continued)
Module 5 Inventory Costing
Methods with a Perpetual System
(Appendix)
Inventory costing methods are applied with a
perpetual system
Inventory Costing Methods with the
Use of a Perpetual Inventory
System
Example 5-19FIFO Costing
Methods with a Perpetual
Inventory System
Example 5-20LIFO Costing
Methods with a Perpetual
Inventory System
Moving Average
An average cost method when a weighted
average cost assumption is used with a
perpetual inventory system
Each time a purchase is made, a new weighted
average cost must be computed, thus the name
moving average
For example, the goods available for sale after
the January 20 purchase consist of 500 units at
$10 and 300 units at $11, which results in an
average cost of $10.38
Review
LO1 Identify the forms of inventory held by different types of
businesses and the types of costs incurred.
Inventory is a current asset held for resale in the normal course of
business. The nature of inventory held depends on whether a
business is a reseller of goods (wholesaler or retailer) or a
manufacturer.
Resellers incur a single cost to purchase inventory held for sale.
Manufacturers incur costs that can be classified as raw materials, direct labor, and
manufacturing overhead.
LO2 Explain how wholesalers and retailers account for sales of
merchandise.
Net sales represents sales less deductions for discounts and
merchandise returned (returns and allowances) and is a key figure on
the income statement.
Sales discounts are given to customers who pay their bills promptly.
Returns and allowances have the same effect on sales that sales discounts do;
that is, they reduce sales.
Review
LO3 Show that you understand how wholesalers and retailers
account for cost of goods sold.
The cost of goods sold represents goods sold, as opposed to the
inventory purchased during the year. Cost of goods sold is matched
with the sales of the period.
The cost of goods sold in any one period is equal to: Beginning inventory +
Purchases Ending inventory.
Under the perpetual method, the Inventory account is updated after each sale or
purchase of merchandise.
In contrast, under the periodic method, the Inventory account is updated only at
the end of the period.
The cost of goods purchased includes any costs necessary to acquire
the goods less any purchase discounts, returns, and allowances.
Transportation-in is the cost to ship goods to a company and is typically classified
as part of cost of goods purchased.
Review
LO4 Use the gross profit ratio to analyze a companys ability to
cover its operating expenses and earn a profit.
The gross profit ratio is the relationship between gross profit and net
sales. Managers, investors, and creditors use this important ratio to
measure one aspect of profitability.
The ratio is calculated as follows: Gross Profit
Net Sales
LO5 Explain the relationship between the valuation of inventory

and the measurement of income.
Inventory costs ultimately become the cost of goods sold reflected in
the income statement.
Since inventory is not expensed as the cost of goods sold until merchandise is
sold, determining which costs belong in inventory affects the timing of when
these expenses are reflected in net income.
Review
LO6 Apply the inventory costing methods of specific
identification, weighted average, FIFO, and LIFO by using a
periodic system.
The purchase price of inventory items may change frequently, and
several alternatives are available to assign costs to the goods sold and
those that remain in ending inventory.
Specific identification assigns the actual costs of acquisition to items of inventory.
In some circumstances, it is not practical to do this.
Three other methods involve making assumptions about the cost of inventory.
Weighted average assigns the same unit cost to all units available for sale during the
period.
The FIFO method assumes that the first units purchased are the first units sold.
The LIFO method assumes that the last units purchased are the first units sold.
Review
LO7 Analyze the effects of the different costing methods on
inventory, net income, income taxes, and cash flow.
The ability to measure net income accurately for a period should be
the driving force behind selecting an inventory costing method.
Inventory costing methods impact the cost of goods sold and, therefore, net
income.
When a company uses LIFO for tax purposes, it must use it for financial reporting
purposes as well.
LO8 Analyze the effects of an inventory error on various financial
statement items.
The link between the balance sheet and the income statement can be
seen through the effect of errors in inventory valuation.
Overstatement of ending inventory results in an understatement of the cost of
goods sold and therefore an overstatement of net income.
The effects of errors in inventory may offset themselves over time. These are
known as counterbalancing errors.
Review
LO9 Apply the lower-of-cost-or-market rule to the valuation of
inventory.
The principle of conservatism in accounting may warrant a departure
from historical cost. This departure is known as the lower-of-cost-or-
market rule (LCM).
Under LCM, the historical cost of inventory is compared with its replacement
cost. If the replacement cost is lower, the Inventory account is reduced and a loss
is recognized.
Review
LO10 Analyze the management of inventory.
Inventory turnover is a measure of how efficiently inventory is
managed. The ratio measures how quickly inventory is sold and is
calculated as follows:
Cost of Goods Sold
Average Inventory
The higher the ratio, the less time inventory resides in storage (i.e.,
the more quickly it turns over).
The average length of time that it takes to sell inventory can be
derived from the inventory turnover ratio:
Number of Days Sales in Inventory = Number of Days in the Period
Inventory Turnover Ratio
Review
LO11 Explain the effects that inventory transactions have on the
statement of cash flows.
Under the indirect method of calculating cash flows from operating
activities, both the changes in the Inventory account and the
Accounts Payable account must be taken into consideration.
LO12 Explain the differences in the accounting for periodic and
perpetual inventory systems and apply the inventory
costing methods using a perpetual system (Appendix).
The three inventory costing methodsFIFO, LIFO, and weighted
averagemay be used in combination with a perpetual inventory
system.
The inventory costing method is applied after each sale of merchandise to update
the Inventory account.
The results from using LIFO differ depending on whether a periodic or perpetual
system is used. The same is true with weighted average, which is called moving
average in a perpetual system.
End of Chapter 5

Financial Accounting - Chapter 5

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Financial Accounting - Chapter 5

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Chapter 5

Inventories and Cost

Cost of goods available for sale

Weighted Number of Units in

Weighted Average Cost x Number of Units in Ending Inventory = Ending Inventory

$11.40 x 600 = $6,840

Weighted Average Cost x Number of Units Sold = Cost of Goods Sold

Survival of LIFO is not only a matter of

Cost of Goods Sold

Number of Days Sales Number of Days in the Period

LO5 Explain the relationship between the valuation of inventory

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