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