9-1 1. Inventory for merchandising & manufacturing business 2. Periodic vs. perpetual inventory systems 3. Recognition of inventory on the books 4. Compute total inventory acquisition cost 5. Inventory valuation methods: specific identification, average cost, FIFO, and LIFO 6. LIFO inventory layers and the LIFO reserve 7. Choose an inventory valuation method 8. The lower-of-cost-or-market (LCM) valuation 9. The gross profit method valuing inventory Chapter 9 Inventory and Cost of Goods Sold
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9-1
1. Inventory for merchandising & manufacturing
business
2. Periodic vs. perpetual inventory systems
3. Recognition of inventory on the books
4. Compute total inventory acquisition cost
5. Inventory valuation methods: specific identification,
average cost, FIFO, and LIFO
6. LIFO inventory layers and the LIFO reserve
7. Choose an inventory valuation method
8. The lower-of-cost-or-market (LCM) valuation
9. The gross profit method valuing inventory
Chapter 9 Inventory and Cost of Goods Sold
9-2
10. Financial statement impact of inventory recording
errors
11. Analyze inventory using financial ratios
12. FIFO, LIFO, average cost, and lower-of-cost-or-
market inventory using the retail inventory method
13. Use LIFO pools, dollar-value LIFO, and dollar-
value LIFO retail to compute ending inventory
14. The impact of changing prices on purchase
commitments
15. Record inventory purchase transactions
denominated in foreign currencies
Chapter 9 Inventory and Cost of Goods Sold
(Continued)
9-3 9-3
9-4 9-4
9-5
What Is Inventory?
• Inventory designates goods held for sale in
the normal course of business or, for a
manufacturer, also includes goods in
production or to be placed into production.
• For some businesses, inventory represents the
most active element in business operations.
• The terms raw materials, work in process,
and finished goods refer to the inventories of
a manufacturing enterprise.
1. Define inventory for a merchandising
business, and identify the different types of
inventory for a manufacturing business
9-6 9-6
9-7
Raw Materials
• Raw Materials are goods acquired to use in
the production process.
• The term direct materials is frequently used
to refer to materials that will be physically
incorporated in the products being
manufactured.
• The term indirect materials is then used to
refer to auxiliary materials, that is, materials
that are necessary in the production process
but not directly incorporated into the product.
9-8
Work in Process
• Work in Process (WIP) consists of
materials partly processed and requiring
further work before they can be sold.
• Work in Process includes three cost
elements.
1. Direct materials
2. Direct labor
3. Manufacturing overhead
(continued)
9-9
1. Direct materials refers to the cost of
materials directly identified with goods in
production.
3. Manufacturing overhead refers to the
portion of factory overhead assignable to
goods in production.
2. Direct labor refers to the cost of labor
directly identified with goods in production.
Work in Process
9-10
Finished Goods
• Finished goods are the manufactured
products awaiting sale.
• As products are completed, the costs
accumulated in the production process are
transferred from Work in Process to the
Finished Goods Inventory account.
9-11 9-11
9-12
Inventory Systems
Two types of inventory systems that keep track of
how much inventory has been sold and at what
price are:
• Periodic inventory system—requires a physical
count of the inventory periodically, and at the
point of sale only records the sale price.
• Perpetual inventory system—at point of sale
records selling price and type of item sold are
recorded. Example: a bar code scanning system.
2. Explain the advantages and disadvantages of
both periodic and perpetual inventory systems
9-13
The following transactions occurred during the
period for CyBorg, Inc.
Beginning inventory 50 units @ $10 $ 500
Purchases during the period 300 units @ $10 3,000
Sales during the period 275 units @ $15 4,125
Ending inventory (physical) 70 units @ $10 700
Beginning inventory 50 units @ $10 $ 500
Purchases during the period 300 units @ $10 3,000
Sales during the period 275 units @ $15 4,125
Ending inventory (physical) 70 units @ $10 700
(continued)
Inventory Systems
9-14
Purchases during the period:
Purchases 3,000
Accounts Payable 3,000
Sales during the period:
Accounts Receivable 4,125
Sales 4,125
Periodic Inventory System Periodic Inventory System
(continued)
Inventory Systems
9-15
Inventory 3,000
Accounts Payable 3,000
Purchases during the period:
Accounts Receivable 4,125
Sales 4,125
Cost of Goods Sold 2,750
Inventory 2,750
Sales during the period:
Perpetual Inventory System Perpetual Inventory System
(continued) 275 units @ $10
Inventory Systems
9-16
Comparison of Methods
The cost of goods sold in the CyBorg example is
computed as follows:
9-17
Whose Inventory Is It?
• As a general rule, goods should be included in the inventory of the business holding legal title.
• The passing of title is a legal term designating the point at which ownership changes.
• Issues that develop:
• Goods in transit
• Goods on consignment
3. Determine when ownership of goods in
transit changes hands and what
circumstances require shipped inventory to
be kept on the books
9-18
Goods in Transit
Whose inventory is it? Whose inventory is it?
When terms of sale are FOB (free on board)
shipping point, title passes to the buyer with
the loading of goods at the point of shipment.
When terms of sale are FOB (free on board)
destination, legal title does not pass until the
goods are received by the buyer.
9-19 9-19
9-20
Goods on Consignment
• Shipper retains title and includes the goods in
inventory until their sale or use by the dealer or
customer.
• Consigned goods are properly reported by
the shipper at the sum of their costs, and the
shipping and handling costs incurred transfer
to the dealer or customer.
9-21
Conditional Sales, Installment Sales, and
Repurchase Agreements
• Conditional sales and installment sales
contracts may provide a retention of title by
the seller until the sales price is fully
recovered.
• As a creative way to obtain cash on a short-
term basis, firms sometimes sell inventory to
another company but at the same time agree
to repurchase the inventory at a future date.
9-22
Inventory costs consist of all expenditures, both
direct and indirect, relating to acquisition,
preparation, and placement for sale.
• Expenditures that are relatively small and
difficult to allocate are period costs.
These are recognized as expenses in the
current period.
Items Included in Inventory Cost
4. Compute total inventory acquisition cost
9-23
• Costs that can be identified with the
product being manufactured are called
product or inventoriable costs.
• Costs arising from idle capacity, excessive
spoilage, and reprocessing are usually
considered abnormal and are expensed in
the current period.
Items Included in Inventory Cost
9-24
• Traditionally, manufacturing overhead costs
have been allocated to products based on the
amount of direct labor required in production.
• Activity-based cost (ABC) systems strive
to allocate overhead based on clearly
identified cost drivers—characteristics of the
production process that are known to create
overhead costs.
Items Included in Inventory Cost
9-25 9-25
9-26
Discounts as Reductions in Cost
• Discounts associated with the purchase of
inventory should be treated as a reduction in
the cost assigned to the inventory.
• Trade discounts refer to the difference
between a catalog price and the price actually
charged to a buyer.
• Cost is defined as the list price less the trade
discount.
9-27
Discounts as Reductions in Cost
• Cash discounts are discounts granted for
payment of invoices within a limited time
period.
• Example: A purchase of $10,000 provides for
payment on a 2/10, n/30 basis. If the buyer
pays by the 10th day, $9,800 settles the
invoice. After that, the full $10,000 is required.
9-28
Discounts as Reductions in Cost
• The net method records inventory at this
discounted amount (i.e., the gross invoice
prices less the allowable discount).
• The net method reflects that discounts not
taken are in effect a finance charge incurred
for failure to pay within the discount period.
9-29 9-29
(continued)
9-30
Discounts as Reductions in Cost
• Under the gross method, cash discounts are
booked only when they are taken.
• While the net method tracks discounts not
taken, the gross method provides no such
information, and inventory records are
maintained at the gross unit price.
• The net method of accounting for purchases
is strongly preferred.
9-31
Purchases Reported Using
the Net Method
To record the purchase of merchandise priced at
$10,000 with a cash discount of 2%:
Inventory 9,800
Accounts Payable 9,800
To record the payment of the invoice within
discount period:
Accounts Payable 9,800
Cash 9,800
9-32
To record payment of the invoice after the
discount period:
Accounts Payable 9,800 Discounts Lost 200 Cash 10,000
To record adjustment at the end of the period if
invoice has not been paid and the discount
period has lapsed:
Discounts Lost 200
Accounts Payable 200
Purchases Reported Using
the Net Method
9-33
Accounts Payable 10,000
Inventory 200
Cash 9,800
To record the purchase of merchandise priced at
$10,000 with a cash discount of 2%:
Inventory 10,000
Accounts Payable 10,000
To record the payment of the invoice within
discount period:
Purchases Reported Using
the Gross Method
9-34
No entry required
To record payment of the invoice after the
discount period:
Accounts Payable 10,000 Cash 10,000
To record adjustment at the end of the period if
invoice has not been paid and the discount
period has lapsed:
Purchases Reported Using
the Gross Method
9-35
Purchase Returns and Allowances
• Adjustments are
also made when
goods are
damaged or are
lesser in quality
than ordered.
• Sometimes the
customer
returns the
goods.
Accounts Payable 400
Purchase Returns
and Allowances 400
Periodic Inventory System
Perpetual Inventory System
Accounts Payable 400
Inventory 400
9-36
Inventory Valuation
Methods Specific
Identification
Last-in, first-
out (LIFO)
Cost
Allocation
Methods
Cost
Allocation
Methods
Average
Cost
First-in, first-
out (FIFO)
5. Use the four basic inventory valuation
methods: specific identification, average
cost, FIFO, and LIFO
9-37 9-37
9-38
Inventory Valuation Methods
The four methods will be illustrated using the
following simple example for Dalton Company.
Note: No beginning inventory
9-39
Specific Identification Method
• This specific identification method requires a
way to identify the historical cost of each
individual unit of inventory.
• From a theoretical standpoint, the specific
identification method is very attractive,
especially when each inventory item is unique
and has a high cost.
• This method opens the door to possible profit
manipulation.
9-40
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
Sold 200 units from the
January 1 and 500 from
the July 15 purchase.
100 units @ $13 per unit
1,100 units
Jan. 1
Mar. 23
July 15
Nov. 6
Purchases:
Specific Identification Method
9-41
200 units @ $10 per unit
500 units @ $11 per unit
Jan. 1
July 15
= $2,000
= 5,500
Total cost of goods sold $7,500
Specific Identification Method
not sold
not sold
9-42
sold
300 units @ $12 per unit
100 units @ $13 per unit
Mar. 23
Nov. 6
= $3,600
= 1,300
Ending inventory $4,900
sold
Specific Identification Method
9-43
Average Cost Method
• The average cost method assigns the same
average cost to each unit.
• This method is based on the assumption that
goods sold should be charged at an average
cost.
• For periodic inventory, the unit cost is the
weighted average for the entire period.
9-44
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
1,100 units
Jan. 1
Mar. 23
July 15
Nov. 6
= $ 2,000
= 3,600
= 5,500
= 1,300
$12,400
$12,400 1,100 units = $11.27 per unit (rounded)
Cost of goods sold = $11.27 700 = $7,890
Ending inventory = $11.27 400 = $4,510
Average Cost Method
9-45
• The First-in, first out (FIFO) method is based
on the assumption that the units sold are the
oldest units on hand.
• FIFO assumes a cost flow closely paralleling the
usual physical flow of goods sold.
• With FIFO, the units remaining in ending
inventory are the most recently purchased units,
so their reported cost would most closely match
end-of-year replacement costs.
First-In, First-Out (FIFO) Method
9-46
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Jan. 1
Mar. 23
July 15
Nov. 6
Total cost of goods sold $7,800
Sold 200
= $2,000
Sold 300 = 3,600
Sold 200 = 2,200
First-In, First-Out (FIFO) Method
200
9-47
First-In, First-Out (FIFO) Method
Jan. 1
Mar. 23
July 15
Nov. 6
= 2,200
= 1,300
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Ending inventory $3,500
200
9-48
Last-In, First-Out (LIFO) Method
• The last-in, first-out (LIFO) method is based
on the assumption that the newest units are
sold first.
• There is no required connection between the
actual physical flow of goods and the
inventory valuation method used.
• LIFO is the best method of matching current
inventory costs with current revenues.
9-49
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Jan. 1
Mar. 23
July 15
Nov. 6
Total cost of goods sold $8,000
= $1,300
= $5,500
= $1,200
Last-In, First-Out (LIFO) Method
200 units @ $12 per unit
9-50
Last-In, First-Out (LIFO) Method
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Jan. 1
Mar. 23
July 15
Nov. 6
Ending inventory $4,400
= $2,400
= $2,000
200 units @ $12 per unit
9-51
9-52
• The complications of a perpetual system are
Illustrated in Exhibit 9-11 (Slides 9-53 and 9-
54), in which Dalton Company’s cost of goods
sold and ending inventory for 2013 are
computed assuming that 300 units were sold
on June 30 and 400 units were sold on
December 31.
• For FIFO, cost of goods sold and ending
inventory are the same whether a periodic
system or perpetual system is used.
Complications with a
Perpetual Inventory System
9-53
Complications with a
Perpetual Inventory System
• Because the newest units (last in) as of June
30 are not the same as the newest units on
December 31, applying LIFO on a perpetual
basis gives a different cost of goods sold and
ending inventory than if a periodic system is
used.
• Applying average cost on a perpetual and a
periodic basis yields different results.
9-54
Inv
en
tory
Valu
ati
on
Me
tho
ds a
nd
Perp
etu
al
Inv
en
tory
Syste
m
9-55 9-55
Inve
nto
ry V
alu
ati
on
Meth
od
s a
nd
Perp
etu
al
Inve
nto
ry S
yste
m
9-56
The following data are for Ryanes Company for the first three
years of its existence:
6. Explain how LIFO inventory layers are
created, and describe the significance of
the LIFO reserve
9-57
• Each year in which the number of units purchased
exceeds the number of units sold, a new LIFO layer
is created in ending inventory.
• Many companies that use LIFO report the amount of
their LIFO reserve, either as a parenthetical note in
the balance or the notes to the financial statements.
LIFO Layers
• The difference between the LIFO ending inventory
amount and the amount obtained using another
inventory valuation method (like FIFO or average
cost) is called the LIFO reserve. For example, in this
case, the LIFO reserve is $350 ($1,350 FIFO ending