Chapter 8
Inventories and Cost of Goods Sold
Inventory and Cost of Goods Sold Inventory
Products purchased or manufactured for Sale to Customers
Beginning Inventory Quantities of Merchandise on hand
Purchases New Purchases or Manufactured products
Available for Sale = Beginning Inventory + Purchases Most that a company can sell during an accounting
periodEnding Inventory
Remaining Unsold MerchandiseCost of Goods Sold
Cost of Inventory Sold during accounting Period
Income Statement
Service revenue $XXXExpenses Salary expense X Depreciation expense X Income tax expense XNet income $ X
Service CompanyCentury 21 Real Estate
Income StatementYear Ended December 31, 20xx
Sales revenue $185Cost of goods sold 146Gross profit 39Operating expenses: Salary expense X Depreciation expense X Income tax expense $ XNet income $ 4
Merchandising CompanyGeneral Motors Corporation
Income StatementYear Ended December 31, 20xx
Balance Sheet
Current assets: Cash $X Short-term investments X Accounts receivable, net X Prepaid expenses X
Service CompanyCentury 21 Real Estate
Balance SheetYear Ended December 31, 20xx
Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 11 Prepaid expenses X
Merchandising CompanyGeneral Motors Corporation
Balance SheetYear Ended December 31, 20xx
Inventory Accounting Systems
PerpetualUp-to-date record in inventory accountCost of goods sold computed for each sale
PeriodicInventory purchases are recorded as incurredInventory and cost of goods sold determined at the
end of each periodCosts and benefits
Perpetual requires more bookkeeping but provides more useful information
Recording Transactions in the Perpetual System
Purchase price of the inventory $600,000+ Freight-in (delivery charges) 4,000– Purchase returns – 25,000– Purchase allowances – 5,000– Purchase discounts – 14,000= Net purchases of inventory $560,000
Net salesSales revenue
– Sales returns & allowances– Sales discounts
Calculation
Periodic System Beginning Inventory+Cost of Purchases___________________=Cost of Goods Available for Sale- Ending Inventory___________________=Cost of Goods Sold
Perpetual SystemBeginning Inventory+Cost of Purchases___________________=Cost of Goods Available for Sale- Cost of Goods Sold___________________=Ending Inventory
Periodic Vs. Perpetual System
Periodic PerpetualPurchase Debited as purchase Debited to Inventory
Sales Sale Entry 2 Entries To record sale & to reduce the inventory
Ending Inventory Not Recorded until the end of a period
Recorded
Cost of Goods Sold Not Recorded until the end of a period
Recorded
Relationship between Balance Sheet and Income StatementIncome Statement Items:
Sales revenue is based on sale price of Inventory sold.
Cost of goods sold is based on cost of Inventory sold.
Gross profit (gross margin) is sales revenue less cost of goods sold.
Balance Sheet Item:Inventory on the balance sheet is based on
cost.
Accounting for Inventory
Sales(income statement) = Number of units of
inventory sold X Sale price per unitof inventory
Cost of Goods Sold(income statement) = Number of units of
inventory sold X Cost per unitof inventory
Inventory(balance sheet) = Number of units of
inventory on hand X Cost per unitof inventory
General Journal
Date Accounts and Explanations LF Debit Credit
Recording Transactions and the T-Accounts
Accounts Payable560,000Beg. 100,000
560,000
Inventory
Inventory 560,000Accounts Payable 560,000
Purchased inventory on account
Recording Transactions and the T-AccountsSale on account $900,000 of Inventory
which cost $540,000:
General JournalDate Accounts and Explanations LF Debit Credit
Accounts Receivable 900,000Sales Revenue 900,000
Cost of Goods Sold 540,000Inventory 540,000
Recording Transactions and the T-Accounts
Cost of Goods Sold540,000
InventoryBeg. 100,000
560,000120,000
540,000
Reporting in the Financial Statements
Income Statement (partial)Sales revenue $900,000Cost of goods sold 540,000Gross profit $360,000
Ending Balance Sheet (partial)Current assets: Cash $ XXX Short-term investments XXX Accounts receivable, net XXX Inventory 120,000 Prepaid expenses XXX
Inventory Costing Method
Methods for determining per unit Inventory CostSpecific unit costAverage costFirst-in, first-out (FIFO) costLast-in, first-out (LIFO) cost
Which Method will a Company Use?Decision is up to Management
NOT based on Actual Inventory MovementsA tool for managing EarningsA tool for managing Taxes
Beginning inventory (10 units @ $10) $ 100No. 1 (25 units @ $14 per unit) $350No. 2 (25 units @ $18 per unit) 450Total purchases 800Cost of 60 goods available for sale $ 900
Ending inventory: 20 unitsCost of goods sold: 40 units
Illustrative Data
Specific Unit Cost
Cost of Goods Sold$ 50 350 180$580
$900 – $580 = $320
25 Units @ $14
10 Units @ $18
5 Units @ $10
Weighted-Average, Average Costing
Average Costper unit =
Cost of Goods AvailableNumber of units available
Inventory (at average cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350Purchases:
25 units @ $18 450Cost of goods sold (40 units @ average cost of $15 per unit 600
Ending Bal (20 units @ average cost of $15 per unit 300
Weighted-Average
$900 total cost ÷ 60 units = $15/unit
Cost of goods sold = 40 × $15 = $600
Ending inventory = 20 × $15 = $300
Inventory (at FIFO cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350Purchases:
25 units @ $18 450
Cost of goods sold (40 units):(10 units @ $10 = 100)(25 units @ $14 = 350)( 5 units @ $18 = 90) 540
Ending Bal (20 units @ $18) 360
First costs into inventory are first costs assigned to cost of goods sold.
First In, First Out
First In, First Out
60 units Less units sold 40 Ending inventory 20 units
Ending Inventory Cost:
20 units × $18 per unit = $360
First In, First Out
Cost of Goods Sold$100 350 90$540
10 Units @ $10
25 Units @ $14
5 Units @ $18
Last In, First Out
Inventory (at LIFO cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350Purchases:
25 units @ $18 450 Cost of goods sold (40 units): (25 units @ $18 = 450)(15 units @ $14 = 210) 660
Ending Bal (10 units @ $10 = 100)(10 units @ $14 = 140) 240
Last costs into inventory are first costs assigned to cost of goods sold.
Last In, First Out
60 units Less units sold 40 Ending inventory 20 units
Ending Inventory Cost:
10 units × 10 = $10010 units × 14 = 140Total $240
Last In, First Out
Cost of Goods Sold$450 210$660
25 Units @ $18
15 Units @ $14
Income Effects of Inventory Methods
Specific unit cost $1,000 – 640 = $360Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340
AssumedSales
Revenue
Cost ofGoodsSold
GrossProfit
Income Effects
When inventory costs are increasingLIFO cost of goods sold is highest, gross profit
is lowest.FIFO cost of goods sold is lowest, gross profit
is highest.When inventory costs are decreasing
FIFO cost of goods sold is highest.LIFO cost of goods sold is lowest.
Tax Advantage
Tax advantages of LIFO in periods of rising pricesHigher Cost of Goods Sold = Lower Net Income
= Lower Income Taxes
Tax advantages of FIFO in periods of falling pricesHigher Cost of Goods Sold = Lower Net Income
= Lower Income Taxes
Tax Advantage
Gross profit $460 $340Operating expenses 260 260Income before taxes $200 $ 80Income tax expense (40%) $ 80 $ 32
FIFO LIFO
The most attractive feature of LIFO is low income tax payments when prices are
increasing.
Inventory in Balance Sheet
LIFO, The inventory will be recorded at the old cost considered to be valued low.
FIFO, The inventory will be recorded at the latest cost, increasing accuracy of balance sheet.
Inventory Errors
Each inventory error affects:InventoryCost of goods soldGross profitNet income
Inventory Errors
Period 1 Period 2
Inventory Error Cost of
Goods Sold Gross Profit
and Net Income Cost of
Goods Sold Gross Profit
and Net Income Period 1 Ending inventory overstated Understated Overstated Overstated Understated Period 1 Ending inventory understated Overstated Understated Understated Overstated
Accounting PrinciplesConsistency principle
Same Accounting Methods from Period to Period Accounting Changes must be disclosed
Effect of accounting Change must be disclosedDisclosure principle
Enough information must be reported for stakeholders to make informed decisions
Relevant, Reliable, and Comparable InformationAccounting conservatism
Anticipate or disclose all likely losses, but gains are not reported until they occur
Assets are recorded as lowest reasonable amount Liabilities are recorded at highest reasonable amount:
Lower of Cost or MarketLower-of-Cost-or-Market rule (LCM)
Inventory is reported at the lowest valueHistorical CostOr Market (Replacement Cost)
Inventory is below costRecord an increase in Cost of Goods Sold (debit)Record the reduction in Inventory (credit)
To record a $1,000 decline in inventory value
Cost of Goods Sold 1,000Inventory 1,000
Wrote inventory down to market value
Ratios
Gross ProfitPercentage =
Gross ProfitNet Sales Revenue
InventoryTurnover =
Cost of goods soldAverage Inventory
Ratios
Gross ProfitProfit indicator
Inventory Turnover – Liquidity ratioHow quickly is Inventory Sold?
Techniques of Estimating Cost of Goods Sold and Ending Inventory
The Gross Profit MethodThe Retail Method
Gross Profit Method
It is assumed that rate of gross profit earned in the preceding year will remain the same in current year.
Is based on the gross margin ratio of the previous year.
Also called gross margin method.
Estimate CGS using GP%
We know Beginning Inventory = $14,000We know Purchases = $ 66,000We know Sales = $100,000We know Gross Profit % = 43%
We Don’t know Cost of Goods SoldWe Don’t know Ending Inventory
Gross Profit Method
Beginning inventory $14,000Purchases 66,000Goods available 80,000Cost of goods sold:
Net sales revenue $100,000Less estimated gross profit 43% (43,000)Estimated cost of goods sold 57,000
Estimated cost of ending inventory$23,000
The Retail Method
Is quite similar to the gross profit method.Retail method is based on the cost ratio of
the current period.
Estimate CGS using Cost%
Cost of goods available for sale= $ 45,000Retail price = $100,000Annual Sales = $
80,000
Cost % = $45,000 ÷ $100,000 = 45 %CGS = Annual Sales * Cost %CGS = $80,000 * 45% = $36,000