Accounting & Financial Reporting

1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Reporting and
Interpreting
Cost of Goods
Sold and
Inventory
Chapter 7

2. 7-2
Understanding the Business
Provide sufficient
quantities of high-
quality inventory.
Minimize the costs of
carrying inventory.
Primary Goals of
Inventory
Management

3. 7-3
Learning Objectives
Apply the cost principle to identify the amounts
that should be included in inventory and the
matching principle to determine cost of goods
sold for typical retailers, wholesalers, and
manufacturers.

4. 7-4
Items Included in Inventory
Inventory
Tangible Held for Sale
Used to
Produce Goods
or Services
Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory

5. 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

6. 7-6
Flow of Inventory Costs
Merchandise
Purchases
Cost of
Goods Sold
Merchandise
Inventory
Merchandiser
Raw
Materials
Raw Materials
Inventory
Work in Process
Inventory
Finished Goods
Inventory
Cost of
Goods Sold
Manufacturer
Direct
Labor
Factory
Overhead

7. 7-7
Nature of Cost of Goods Sold
Beginning
Inventory
Purchases
for the Period
Ending Inventory
(Balance Sheet)
Goods available
for Sale
Cost of Goods Sold
(Income Statement)
Beginning inventory + Purchases = Goods Available for Sale
Goods Available for Sale – Ending inventory = Cost of goods sold

8. 7-8
Learning Objectives
Report inventory and cost of goods sold using
the four inventory costing methods.

9. 7-9
Inventory Costing Methods
Specific
Identification FIFO
LIFO
Weighted
Average

10. 7-10
Inventory Costing Methods
Total Dollar Amount of Goods
Available for Sale
Ending Inventory Cost of Goods Sold
Inventory
Costing Method

11. 7-11
Specific Identification
When units are
sold, the
specific cost
of the unit sold
is added to
cost of goods
sold.

12. 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.

13. 7-13
First-In, First-Out Method
Cost of
Goods Sold
Oldest Costs
Ending
Inventory
Recent Costs

14. 7-14
First-In, First-Out
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.
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200 ?
Cost of
Goods Sold 1,050 ?

15. 7-15
First-In, First-Out
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 Units
Ending Inventory
Cost of Goods
Sold
Given Information

16. 7-16
First-In, First-Out
Now, we have allocated the cost to all
1,200 units in 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 Units
6,695
$ Cost
Ending Inventory
Cost of Goods
Sold
Given Information

17. 7-17
First-In, First-Out
Now, we have allocated the cost to all
1,050 units sold.
Beg. Inv. 1,000 @ 5.25
$ 1,000 @ 5.25
$
Jan. 3 500 @ 5.30 450 @ $5.30 50 @ 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 1,050 Units
6,695
$ Cost 5,515
$ Cost
Ending Inventory
Cost of Goods
Sold
Given Information

18. 7-18
First-In, First-Out
Here is the
cost of
ending
inventory
and cost
of goods
sold using
FIFO.
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200 6,695.00
$
Cost of
Goods Sold 1,050 5,515.00
$

19. 7-19
Last-In, First-Out Method
Ending
Inventory
Cost of
Goods Sold
Oldest Costs
Recent Costs

20. 7-20
Last-In, First-Out
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.
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200 ?
Cost of
Goods Sold 1,050 ?

21. 7-21
Last-In, First-Out
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 Units
Ending Inventory
Cost of Goods
Sold
Given Information

22. 7-22
Last-In, First-Out
Now, we have allocated the cost to all
1,200 units in 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 Units
6,310
$ Cost
Ending Inventory
Cost of Goods
Sold
Given Information

23. 7-23
Last-In, First-Out
Now, we have allocated the cost to all
1,050 units sold.
Beg. Inv. 1,000 @ 5.25
$ 1,000 @ $5.25
Jan. 3 500 @ 5.30 200 @ 5.30 300 @ 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 1,050 Units
6,310
$ Cost 5,900
$ Cost
Ending Inventory
Cost of Goods
Sold
Given Information

24. 7-24
Last-In, First-Out
Here is the
cost of
ending
inventory
and cost of
goods sold
using LIFO.
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200 6,310.00
$
Cost of
Goods Sold 1,050 5,900.00
$

25. 7-25
Average Cost Method
When a unit is sold, the
average cost of each unit in
inventory is assigned to cost
of goods sold.
Cost of Goods
Available for
Sale
Number of
Units
Available for
Sale
÷

26. 7-26
Average Cost Method
12,210
$
2,250
= $5.42667
Weighted Average Cost
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200
Cost of
Goods Sold 1,050

27. 7-27
Average Cost Method
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 5.25
$ 5,250.00
$
Purchases:
Jan. 3 500 5.30 2,650.00
June 20 300 5.60 1,680.00
Sept. 15 250 5.80 1,450.00
Nov. 29 200 5.90 1,180.00
Goods
Available
for Sale 2,250 12,210.00
$
Ending
Inventory 1,200 6,512.00
$
Cost of
Goods Sold 1,050 5,698.00
$
12,210
$
2,250
= $5.42667
Weighted Average Cost
1,200 × 5.42667
$
1,050 × 5.42667
$

28. 7-28
Comparison of Methods
FIFO LIFO
Weighted
Average
Net sales 25,000
$ 25,000
$ 25,000
$
Cost of goods sold:
Merchandise inventory, beginning 5,250
$ 5,250
$ 5,250
$
Net purchases 6,960 6,960 6,960
Goods available for sale 12,210
$ 12,210
$ 12,210
$
Merchandise inventory, ending 6,695 6,310 6,512
Cost of goods sold 5,515
$ 5,900
$ 5,698
$
Gross profit 19,485
$ 19,100
$ 19,302
$
Operating expenses 750 750 750
Income before taxes 18,735
$ 18,350
$ 18,552
$
Income taxes expense (30%)* 5,621 5,505 5,566
Net income 13,114
$ 12,845
$ 12,986
$
* Tax expense amounts were rounded.
Computers, Inc.
Income Statement
For Year Ended December 31, 2006

29. 7-29
Financial Statement Effects of Costing
Methods
Advantages of Methods
Better matches
current costs in cost
of goods sold with
revenues.
Ending inventory
approximates
current
replacement cost.
First-In,
First-Out
Last-In,
First-Out
Smoothes out
price changes.
Weighted
Average

30. 7-30
Learning Objectives
Decide when the use of different inventory
costing methods is beneficial to a company.

31. 7-31
Managers Choice of Inventory Methods
Net Income Effects
Managers prefer to report
higher earnings for their
companies.
Income Tax Effects
Managers prefer to pay
the least amount of taxes
allowed by law as late as
possible.

32. 7-32
Choosing Inventory Costing Methods
LIFO for
books
LIFO for
taxes
If . . . Then . . .
LIFO
Conformity
Rule

33. 7-33
Learning Objectives
Report inventory at the lower of cost or market
(LCM).

34. 7-34
Valuation at Lower of Cost or Market
Ending inventory is reported at the
lower of cost or market (LCM).
Replacement Cost
The current purchase price
for identical 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.

35. 7-35
Valuation at Lower of Cost or Market
Item Quantity Cost
Replacement
Cost LCM Total LCM
Pentium chips 1,000 250
$ 200
$ 200
$ 200,000
$
Disk drives 400 100 110 100 40,000
Debit Credit
Cost of goods sold 50,000
Inventory 50,000
Date Description
GENERAL JOURNAL

36. 7-36
Learning Objectives
Evaluate inventory management using the
inventory turnover ratio and the effects of
inventory on cash flows.

37. 7-37
Inventory Turnover
Cost of Goods Sold
=
Average Inventory
Inventory
Turnover
Average Inventory is . . .
(Beginning Inventory + Ending Inventory) ÷ 2
This ratio reflects how many times
average inventory was produced and
sold during the period. A higher ratio
indicates that inventory moves more
quickly thus reducing storage and
obsolescence costs.

38. 7-38
Inventory and Cash Flows
Add
Subtract
Cash
Payment to
Suppliers
Cost of
Goods
Sold
Increase in Inventory
Decrease in Accounts
Payable
Decrease in Inventory
Increase in Accounts
Payable

39. 7-39
Learning Objectives
Compare companies that use different
inventory costing methods.

40. 7-40
Inventory Methods and Financial Statement
Analysis
Beginning LIFO Reserve
- Ending LIFO Reserve
Difference in COGS Under FIFO
Beginning inventory FIFO
- Beginning inventory LIFO
Beginning LIFO Reserve
(Excess of FIFO over LIFO)
Ending inventory FIFO
- Ending inventory LIFO
Ending LIFO Reserve
(Excess of FIFO over LIFO)
U.S. public companies using LIFO also report beginning
and ending inventory on a FIFO basis if the FIFO values
are materially different.

41. 7-41
LIFO and International Comparisons
LIFO Permitted?
Yes
No
China
Singapore
Canada
Great Britain
Australia

42. 7-42
Learning Objectives
Understand methods for controlling and
keeping track of inventory and analyze the
effects of inventory errors on financial
statements.

43. 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.

44. 7-44
Perpetual and Periodic Inventory Systems
Provides up-to-date
inventory records.
Provides up-to-date
cost of sales records.
Perpetual
System
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.

45. 7-45
Perpetual and Periodic Inventory Systems
Inventory System
Item Periodic System Perpetual System
Beginning Inventory
Carried over
from prior period
Carried over from
prior period
Add: Purchases
Accumulated in
the Purchases
account
Accumulated in
the Inventory
account
Less: Ending Inventory
Measured at end
of period by
physical
inventory count
Perpetual record
updated at every
sale
Cost of Goods Sold
Computed as a
residual amount
at end of period
Measured at
every sale based
on perpetual
record

46. 7-46
Errors in Measuring Ending Inventory
Errors in Measuring Inventory
Ending Inventory Beginning Inventory
Overstated Understated Overstated Understated
Ending Inventory + - N/A N/A
Retained Earnings + - - +
Goods Available for Sale N/A N/A + -
Cost of Goods Sold - + + -
Gross Profit + - - +
Net Income + - - +
Effect on Current Period's Balance Sheet
Effect on n Current Period's Income Statement

47. 7-47
LIFO Liquidations
Chapter Supplement A

48. 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.

49. 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.

50. 7-50
Additional Issues in Measuring
Purchases
Chapter Supplement B

51. 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.

52. 7-52
Purchase Discounts
Terms
Time
Due
Discount Period
Full amount
less discount
Credit Period
Full amount due
Purchase or Sale
A purchase discount is a cash discount received for
prompt payment of an account.

53. 7-53
2/10,n/30
Purchase Discounts
Discount
Percent
Number of
Days
Discount Is
Available
Otherwise,
Net (or All)
Is Due
Credit
Period

54. 7-54
Purchase Discounts
Purchases paid for
within the discount
period reduce the
Inventory account for
the amount of the cash
discount received.

55. 7-55
Chapter Supplement C
Comparison of Perpetual and
Periodic Inventory Systems

56. 7-56
Perpetual Inventory System
Jan. 1
Apr. 14 Purchased 1,100 units at a unit cost of $50.
Inventory 55,000
Accounts payable 55,000
Nov. 30 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
Dec. 31 Use cost of goods sold and inventory amounts.
Had beginning inventory of 800 units at a unit cost of
$50.

57. 7-57
Periodic Inventory System
Jan. 1
Apr. 14 Purchased 1,100 units at a unit cost of $50.
Purchases 55,000
Accounts payable 55,000
Nov. 30 Sold 1,300 units at a sales price of $83.
Accounts receivable 107,900
Sales revenue 107,900
Dec. 31 Count the number of units on hand.
Compute the dollar valuation of the ending inventory.
Compute and record the cost of goods sold.
Cost of goods sold 95,000
Inventory (beginning) 40,000
Purchases 55,000
Inventory (ending) 30,000
Cost of goods sold 30,000
Had beginning inventory of 800 units at a unit cost of $50.

58. 7-58
End of Chapter 7