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

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting and Interpreting

Cost of Goods Sold and Inventory

Chapter 7

7-2

Understanding the Business

Provide sufficient Provide sufficient quantities of high-quantities of high-quality inventory.quality inventory.

Provide sufficient Provide sufficient quantities of high-quantities of high-quality inventory.quality inventory.

Minimize the costs of Minimize the costs of carrying inventory.carrying inventory.

Minimize the costs of Minimize the costs of carrying inventory.carrying inventory.

Primary Goals of Inventory

Management

Primary Goals of Inventory

Management

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.

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.

7-4

Items Included in Inventory

Inventory

Tangible Held for SaleUsed to

Produce Goods or Services

Merchandise InventoryRaw Materials Inventory

Work in Process InventoryFinished Goods Inventory

7-5

Costs Included in Inventory Purchases

The cost principlecost principle requires that inventory be recorded at the price paid or the

consideration given.

Invoice Price

Freight

Inspection Costs

Preparation Costs

7-6

Flow of Inventory Costs

MerchandiseMerchandisePurchasesPurchases

MerchandiseMerchandisePurchasesPurchases

Cost ofCost ofGoods SoldGoods Sold


MerchandiseMerchandiseInventoryInventory

MerchandiseMerchandiseInventoryInventory

Merchandiser

RawRawMaterialsMaterials

RawRawMaterialsMaterials

Raw MaterialsRaw MaterialsInventoryInventory

Raw MaterialsRaw MaterialsInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Finished GoodsFinished GoodsInventoryInventory

Finished GoodsFinished GoodsInventoryInventory



Manufacturer

DirectDirectLaborLaborDirectDirectLaborLabor

FactoryFactoryOverheadOverheadFactoryFactory

OverheadOverhead

7-7

Nature of Cost of Goods Sold

BeginningBeginningInventoryInventory

BeginningBeginningInventoryInventory

PurchasesPurchasesfor the Periodfor the PeriodPurchasesPurchases

for the Periodfor the Period

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Goods availableGoods availablefor Salefor Sale

Goods availableGoods availablefor Salefor Sale

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Beginning inventory + Purchases = Goods Available for SaleBeginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of goods soldGoods Available for Sale – Ending inventory = Cost of goods sold

Beginning inventory + Purchases = Goods Available for SaleBeginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of goods soldGoods Available for Sale – Ending inventory = Cost of goods sold

7-8

Learning Objectives

Report inventory and cost of goods sold using the four inventory costing methods.

Report inventory and cost of goods sold using the four inventory costing methods.

7-9

Inventory Costing Methods

Specific Specific IdentificationIdentification

Specific Specific IdentificationIdentification FIFOFIFOFIFOFIFO

LIFOLIFOLIFOLIFO Weighted Weighted AverageAverage

Weighted Weighted AverageAverage

7-10

Inventory Costing Methods

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Ending InventoryEnding InventoryEnding InventoryEnding Inventory Cost of Goods SoldCost of Goods SoldCost of Goods SoldCost of Goods Sold

Inventory Costing Method

7-11

Specific Identification

When units are sold, the

specific cost of the unit sold

is added to cost of goods

sold.

When units are sold, the

specific cost of the unit sold

is added to cost of goods

sold.

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.

7-13

First-In, First-Out Method

Cost of Cost of Goods SoldGoods Sold

Cost of Cost of Goods SoldGoods SoldOldest CostsOldest CostsOldest CostsOldest Costs

Ending Ending InventoryInventoryEnding Ending

InventoryInventoryRecent CostsRecent CostsRecent CostsRecent Costs

7-14

First-In, First-Out

Remember: Remember: The costs of The costs of most most recent recent

purchasespurchases are are in ending in ending inventory. inventory. Start with Start with

11/29 and add 11/29 and add units units

purchased purchased until you reach until you reach the number in the number in

ending ending inventory.inventory.

Computers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 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 ?





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 InventoryCost of Goods

SoldGiven Information

7-16

First-In, First-Out

Now, we have allocated the cost to all Now, we have allocated the cost to all 1,200 units in ending inventory.1,200 units in ending inventory.


Beg. Inv. 1,000 @ 5.25$ Jan. 3 500 @ 5.30 450 @ $5.30June 20 300 @ 5.60 300 @ $5.60Sept. 15 250 @ 5.80 250 @ $5.80Nov. 29 200 @ 5.90 200 @ $5.90

1,200 Units Units

6,695$ Cost



7-17

First-In, First-Out

Now, we have allocated the cost to all Now, we have allocated the cost to all 1,050 units sold.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 @ $5.60Sept. 15 250 @ 5.80 250 @ $5.80Nov. 29 200 @ 5.90 200 @ $5.90

1,200 Units 1,050 Units

6,695$ Cost 5,515$ Cost



7-18

First-In, First-Out

Here is the Here is the cost of cost of ending ending

inventory inventory and cost and cost of goods of goods

sold using sold using FIFO.FIFO.



Ending Inventory 1,200 6,695.00$

Cost of Goods Sold 1,050 5,515.00$





7-19

Last-In, First-Out Method

Ending Ending InventoryInventoryEnding Ending

InventoryInventory



Oldest CostsOldest CostsOldest CostsOldest Costs

Recent CostsRecent CostsRecent CostsRecent Costs

7-20

Last-In, First-Out

Remember: Remember: The costs of the The costs of the

oldest oldest purchasespurchases are are

in ending in ending inventory. Start inventory. Start with beginning with beginning inventory and inventory and

add units add units purchased until purchased until you reach the you reach the

number in number in ending ending

inventory.inventory.

Remember: Remember: The costs of the The costs of the

oldest oldest purchasespurchases are are

in ending in ending inventory. Start inventory. Start with beginning with beginning inventory and inventory and

add units add units purchased until purchased until you reach the you reach the

number in number in ending ending

inventory.inventory.









7-21

Last-In, First-Out

Beg. Inv. 1,000 @ 5.25$ 1,000 @ $5.25Jan. 3 500 @ 5.30 June 20 300 @ 5.60 Sept. 15 250 @ 5.80 Nov. 29 200 @ 5.90

1,000 Units Units



7-22

Last-In, First-Out



Beg. Inv. 1,000 @ 5.25$ 1,000 @ $5.25Jan. 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



7-23

Last-In, First-Out



Beg. Inv. 1,000 @ 5.25$ 1,000 @ $5.25Jan. 3 500 @ 5.30 200 @ 5.30 300 @ 5.30$ 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



7-24

Last-In, First-Out


inventory inventory and cost of and cost of goods sold goods sold using LIFO.using LIFO.


inventory inventory and cost of and cost of goods sold goods sold using LIFO.using LIFO.









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.

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

÷

7-26

Average Cost Method

12,210$ 2,250

= $5.42667

Weighted Average Cost



Ending Inventory 1,200

Cost of Goods Sold 1,050



Ending Inventory 1,200

Cost of Goods Sold 1,050

7-27

Average Cost MethodComputers, Inc.

Mouse Pad InventoryDate 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$







12,210$ 2,250

= $5.42667

Weighted Average Cost

1,200 × 5.42667$

1,050 × 5.42667$

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

7-29

Financial Statement Effects of Costing Methods

Advantages of MethodsAdvantages of MethodsAdvantages of MethodsAdvantages of Methods

Better matches Better matches current costs in cost current costs in cost of goods sold with of goods sold with

revenues.revenues.

Better matches Better matches current costs in cost current costs in cost of goods sold with of goods sold with

revenues.revenues.

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

First-In, First-In, First-OutFirst-OutFirst-In, First-In, First-OutFirst-Out

Last-In, Last-In, First-OutFirst-OutLast-In, Last-In,

First-OutFirst-Out

Smoothes out Smoothes out price changes.price changes.Smoothes out Smoothes out price changes.price changes.



7-30

Learning Objectives

Decide when the use of different inventory costing methods is beneficial to a company.Decide when the use of different inventory

costing methods is beneficial to a company.

7-31

Managers Choice of Inventory Methods

Net Income EffectsNet Income EffectsManagers prefer to report Managers prefer to report higher earnings for their higher earnings for their

companies.companies.

Net Income EffectsNet Income EffectsManagers prefer to report Managers prefer to report higher earnings for their higher earnings for their

companies.companies.

Income Tax EffectsIncome Tax EffectsManagers prefer to pay Managers prefer to pay

the least amount of taxes the least amount of taxes allowed by law as late as allowed by law as late as

possible.possible.

Income Tax EffectsIncome Tax EffectsManagers prefer to pay Managers prefer to pay

the least amount of taxes the least amount of taxes allowed by law as late as allowed by law as late as

possible.possible.

7-32

Choosing Inventory Costing Methods

LIFO for books

LIFO for books

LIFO for taxes

LIFO for taxes

If . . . Then . . .LIFO Conformity

Rule

7-33

Learning Objectives

Report inventory at the lower of cost or market (LCM).

Report inventory at the lower of cost or market (LCM).

7-34

Valuation at Lower of Cost or Market

Ending inventory is reported at the Ending inventory is reported at the lower of cost or market (LCM)lower of cost or market (LCM). .

Ending inventory is reported at the Ending inventory is reported at the lower of cost or market (LCM)lower of cost or market (LCM). .

Replacement CostReplacement CostThe current purchase price The current purchase price

for identical goods.for identical goods.

Replacement CostReplacement CostThe current purchase price The current purchase price

for identical goods.for identical goods.

The company will recognize a “holding” loss in the The company will recognize a “holding” loss in the current period rather than the period in which the current period rather than the period in which the

item is sold.item is sold.This practice is This practice is conservativeconservative..

The company will recognize a “holding” loss in the The company will recognize a “holding” loss in the current period rather than the period in which the current period rather than the period in which the

item is sold.item is sold.This practice is This practice is conservativeconservative..

7-35

Valuation at Lower of Cost or Market

Item Quantity Cost Replacement

Cost LCM Total LCMPentium chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

Item Quantity Cost Replacement

Cost LCM Total LCMPentium chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

7-36

Learning Objectives

Evaluate inventory management using the inventory turnover ratio and the effects of

inventory on cash flows.

Evaluate inventory management using the inventory turnover ratio and the effects of

inventory on cash flows.

7-37

Inventory Turnover

Cost of Goods Sold = Average Inventory

Inventory Turnover

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

This ratio reflects how many times This ratio reflects how many times average inventory was produced and average inventory was produced and sold during the period. A higher ratio sold during the period. A higher ratio indicates that inventory moves more indicates that inventory moves more quickly thus reducing storage and quickly thus reducing storage and

obsolescence costs. obsolescence costs.

This ratio reflects how many times This ratio reflects how many times average inventory was produced and average inventory was produced and sold during the period. A higher ratio sold during the period. A higher ratio indicates that inventory moves more indicates that inventory moves more quickly thus reducing storage and quickly thus reducing storage and

obsolescence costs. obsolescence costs.

7-38

Inventory and Cash Flows

Add

Subtract

Cash Cash Payment to Payment to SuppliersSuppliers

Cash Cash Payment to Payment to SuppliersSuppliers

Cost of Cost of Goods Goods SoldSold

Cost of Cost of Goods Goods SoldSold

Increase in InventoryIncrease in InventoryDecrease in Accounts Decrease in Accounts

PayablePayable

Increase in InventoryIncrease in InventoryDecrease in Accounts Decrease in Accounts

PayablePayable

Decrease in Inventory Decrease in Inventory Increase in Accounts Increase in Accounts

PayablePayable

Decrease in Inventory Decrease in Inventory Increase in Accounts Increase in Accounts

PayablePayable

7-39

Learning Objectives

Compare companies that use different inventory costing methods.

Compare companies that use different inventory costing methods.

7-40

Inventory Methods and Financial Statement Analysis

Beginning inventory FIFO- Beginning inventory LIFO

Beginning LIFO Reserve(Excess of FIFO over LIFO)

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)

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.

7-41

LIFO and International Comparisons

LIFO Permitted?LIFO Permitted?

YesYesNoNo

ChinaSingapore

Canada

Great Britain

Australia

7-42

Learning Objectives

Understand methods for controlling and keeping track of inventory and analyze the

effects of inventory errors on financial statements.

Understand methods for controlling and keeping track of inventory and analyze the

effects of inventory errors on financial statements.

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.

7-44

Perpetual and Periodic Inventory Systems

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-date up-to-date cost of sales records. cost of sales records. Provides Provides up-to-date up-to-date

cost of sales records. cost of sales records.

Perpetual Perpetual SystemSystem

Perpetual Perpetual SystemSystem

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.

7-45

Perpetual and Periodic Inventory Systems

Inventory System

Item Periodic System Perpetual System

Beginning InventoryCarried over

from prior periodCarried over from

prior period

Add: PurchasesAccumulated 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

7-46

Errors in Measuring Ending Inventory

Errors in Measuring InventoryEnding 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

7-47

LIFO LiquidationsLIFO Liquidations

Chapter Supplement A

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.

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.

7-50

Additional Issues in Measuring Purchases

Additional Issues in Measuring Purchases

Chapter Supplement B

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.

7-52

Purchase Discounts

Terms

Time

Due

Discount Period

Full amountless discount

Credit Period

Full amount due

Purchase or SalePurchase or Sale

A purchase discount is a cash discount received for prompt payment of an account.

7-53

2/10,n/302/10,n/30

Purchase Discounts

Discount Percent

Discount Percent

Number of Days

Discount Is Available

Number of Days

Discount Is Available

Otherwise, Net (or All)

Is Due

Otherwise, Net (or All)

Is Due CreditPeriod

CreditPeriod

7-54

Purchase Discounts

Purchases paid for within the discount period reduce the

Inventory account for the amount of the cash

discount received.

7-55

Chapter Supplement C

Comparison of Perpetual and Periodic Inventory Systems

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.

7-57

Periodic Inventory System

7-58

End of Chapter 7

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

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