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Inventories and
Cost of Goods Sold
© 2006 Prentice Hall Business Publishing
CHAPTER
Introduction to Financial Accounting, 9/e
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Learning Objectives
After studying this chapter, you should be able to
1.
2.
3.
4.
Link inventory valuation to gross profit
Use both perpetual and periodic inventory systems
Calculate the cost of merchandise acquired
Compute income and inventory values using the
four principal inventory valuation methods
5. Calculate the impact on net income of LIFO
liquidations
6. Use the lower-of-cost-or-market method to value
inventories
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Learning Objectives
After studying this chapter, you should be able to
7. Show the effects of inventory errors on financial
statements
8. Evaluate the gross profit percentage and inventory
turnover
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Gross Profit and Cost of Goods Sold
• Companies report products being held prior to
sale as inventory—a current asset on the
balance sheet
• When the products are sold, the cost of the
inventory becomes Cost of Goods Sold in the
income statement
• Net Sales less Cost of Goods Sold equals
Gross Profit
• Gross Profit less additional expenses equals Net
Income
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Gross Profit and Cost of Goods Sold
Balance Sheet
Income Statement
Sales
Minus
Merchandise
Purchases
Merchandise
Merchandise
Sales
Inventory
Cost of
Goods Sold
(an expense)
Equals Gross Profit
Minus
Selling
Expenses and
Administrative
Expenses
Equals Net Income
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Perpetual and Periodic
Inventory Systems
• There are two main systems for keeping
inventory records:
– Perpetual system
– Periodic system
• The perpetual inventory system keeps a
continuous record of inventories and cost of
goods sold
• The periodic inventory system computes cost
of goods sold and an updated inventory balance
only at the end of the accounting period
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Perpetual Inventory System
• In the perpetual inventory system, the journal
entries are:
– When inventory is purchased:
Merchandise inventory
Accounts payable
xxx
xxx
– When inventory is sold:
Accounts receivable
Sales
xxx
Cost of goods sold
Inventory
xxx
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Introduction to Financial Accounting, 9/e
xxx
xxx
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Periodic Inventory System
• Under the periodic system, the calculation of
cost of goods sold is delayed until there is a
physical count:
Beginning inventories (by physical count)
Add: Purchases
Cost of goods available for sale
Less: Ending inventories (by physical count)
Cost of goods sold
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XXX
XXX
XXX
XXX
XXX
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Physical Inventory
• Inventory control procedures require a physical
count of items held in inventory at least annually
in both periodic and perpetual inventory systems
• Firms often choose fiscal accounting periods so
that the year ends when inventories are low
• External auditors usually observe the client’s
physical count and confirm its accuracy
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Cost of Merchandise Acquired
• The cost of merchandise includes the invoice
price plus the directly identifiable inbound
transportation charges less any offsetting
discounts
• The costs of purchasing and receiving are
period costs and are charged on the income
statement as they occur
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Transportation Charges
• When the seller bears the transportation cost,
the sales invoice reads free onboard or F.O.B.
destination
• When the buyer bears the transportation cost, it
reads F.O.B. shipping point
• In practice, accountants frequently use a
separate transportation cost account, Freight-in
• Freight-in appears in the purchases section of
an income statement as an additional cost of the
goods acquired during the period
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Returns, Allowances, and Discounts
• Using the periodic inventory system, suppose a
company’s gross purchases are $960,000 and
purchase returns and allowances are $75,000.
The summary journal entries are:
Purchases
Accounts payable
Accounts payable
Purchase returns and allowances
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960,000
960,000
75,000
75,000
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Returns, Allowances, and Discounts
• Suppose also that the company takes cash
discounts of $5,000 on payment of the
remaining $960,000 - $75,000 = $885,000 of
payables. The summary journal entry is:
Accounts payable
Cash discounts on purchases
Cash
885,000
5,000
880,000
• To calculate cost of goods sold, Cash Discounts
on Purchases and Purchase Returns and
Allowances are subtracted from Purchases
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Detailed Gross Profit Calculation
($ in thousands)
Gross sales
$1,740
Deduct: Sales returns and allowances
$ 70
Cash discounts on sales
100
170
Net sales
$1,570
Deduct: Cost of goods sold
Merchandise inventory, December 31, 20X1
$ 100
Purchases (gross)
$ 960
Deduct: Purchase returns and allowances
$ 75
Cash discounts on purchases
5
80
Net purchases
$ 880
Add: Freight-in
30
Total cost of merchandise acquired
910
Cost of goods available for sale
$1,010
Deduct: Merchandise inventory, December 31, 20X2
140
Cost of goods sold
870
Gross profit
$ 700
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Principal Inventory Valuation Methods
• In both systems, we must determine the costs of
individual items by some inventory valuation
method.
• Four principal inventory valuation methods are
generally accepted:
–
–
–
–
Specific identification
First-in, first-out (FIF0)
Last-in, first out (LIFO)
Weighted-average
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Specific Identification
• The specific identification method
concentrates on physically linking the particular
items sold with the cost of goods sold that is
reported
• This method is relatively easy to use for
expensive low-volume merchandise
• The use of bar cods and scanning equipment
makes specific identification economically
feasible for many companies
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FIFO
• FIFO assigns the cost of the earliest acquired
units to cost of goods sold
• The costs of the newer units is assigned to the
units in ending inventory
• FIFO provides inventory valuations that closely
approximate the actual market value of the
inventory at the balance sheet date
• In periods of rising prices, FIFO leads to higher
net income
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LIFO
• LIFO assigns the most recent cost to cost of goods sold
• LIFO provides an income statement perspective in that
net income measured using LIFO combines current
sales prices and current acquisition costs
• In a period of rising prices and constant or growing
inventories, LIFO yields lower net income
• The Internal Revenue Cods requires companies that use
LIFO for tax purposes to also use it for financial reporting
purposes
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Weighted Average
• The weighted-average method computes a
unit cost by dividing the total acquisition cost of
all items available for sale by the number of units
available for sale
• The weighted-average method produces gross
profit somewhere between that obtained under
FIFO and LIFO
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Inventory Valuation Methods Example
• Assume a vendor of soft drinks starts out the
week with no inventory
• He buys and sells cola as follows:
–
–
–
–
Buys one can on Monday for 30 cents
Buys one can on Tuesday for 40 cents
Buys one can on Wednesday for 56 cents
Sells one can on Thursday for 90 cents
• The next slide shows the vendor’s cost of goods
sold and ending inventory under the four
methods
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Inventory Valuation Methods Example
(1)
Specific
Identification
(1A) (1B) (1C)
Income Statement for the Period Monday
through Thursday:
Sales
Deduct cost of goods sold:
1 30 cents (Monday) unit
1 40 cents (Tuesday) unit
1 56 cents (Wednesday) unit
1 weighted-average unit
[(30+40+56) / 3 = 42]
Gross profit for Monday through Thursday
Thursday's ending inventory, 2 units
Monday unit @ 30 cents
Tuesday unit @ 40 cents
Wednesday unit @ 56 cents
Weighted-average units @ 42 cents
Total ending inventory on Thursday
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90
90
90
30
(2)
FIFO
90
(3)
(4)
Weighted
LIFO Average
90
90
30
40
56
60
40
56
96
50
34
30
30
40
56
86
Introduction to Financial Accounting, 9/e
70
56
60
40
56
96
34
42
48
30
40
70
84
84
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Cost Flow Assumptions
• Companies may choose any of the four methods
to record cost of goods sold
• Three out of the four methods are not linked to
the physical flow of merchandise
• Accountants often refer to inventory methods as
cost flow assumptions
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Inventory Cost Relationships
• The difference in the four methods centers
on how inventory costs are allocated
between inventory and cost of sales
• The difference between FIFO and LIFO is:
Inventory Method
Period of Rising Prices
Period of Falling Prices
FIFO
Higher ending inventory
Lower cost of goods sold
Higher net income
Lower ending inventory
Higher cost of goods sold
Lower net income
LIFO
Lower ending inventory
Higher cost of goods sold
Lower net income
Higher ending inventory
Lower cost of goods sold
Higher net income
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The Consistency Convention
• Companies can choose any inventory cost flow
assumption, but they must be consistent over
time with the method they choose
• Consistency is defined as “conformity from
period to period with unchanging policies and
procedures”
• A change in market conditions may justify a
change in inventory method
• The firm must note the change in its financial
statements
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Characteristics and
Consequences of LIFO
• LIFO
– Is widely used in the United States
– Has strong tax benefits for companies
– Has some unusual features
• Few companies outside the U. S. use LIFO
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Holding Gains and Inventory Profits
• LIFO matches the most recent acquisition cost
with sales revenues
• LIFO cost of goods sold typically offers a close
approximation to the replacement cost
• Reported net income rarely contains significant
holding gains
• FIFO reports a profit which includes an
economic profit plus the holding gain because
the value of the inventory rises over time
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LIFO Layers
• A LIFO layer is an addition to inventory at an
identifiable cost level
• As a company grows, the LIFO layers pile on top
of one another over the years
• LIFO inventory values may be far below market
value or current replacement value of the
inventory
• While LIFO better presents the economic reality
on the income statement, FIFO provides more
current valuations on the balance sheet
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LIFO Inventory Liquidations
• A LIFO liquidation occurs when the physical
amount of inventory decreases, and the cost of
goods sold consists of old, low inventory
acquisition costs associated with old LIFO layers
• A LIFO liquidation means that the current year’s
income includes the cumulative inventory profit
from years of increasing prices
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LIFO Inventory Liquidations
• The difference between a company’s LIFO
inventory level and what it would be under FIFO
is called a LIFO reserve
• Most companies that use LIFO explicitly
measure and report their LIFO reserve on the
balance sheet itself or in the footnotes
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Lower-of-Cost-or-Market Method
• The lower-of-cost-or-market method (LCM)
requires a comparison of the current market
price of inventory with historical cost derived
under one of the four primary methods used
• The lower of the two amounts is reported as the
inventory value
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Role of Replacement Cost
• Market price is generally considered to be the
replacement cost of the inventory item—what it
would cost to buy the inventory item today
• A write-down reduces the recorded historical
cost of an item in response to a decline in value
• The required journal entry for a write-down is:
Loss on write-down of inventory (or cost of goods sold) XX
Inventory
XX
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Effects of Inventory Errors
• An undiscovered inventory error usually affects
two reporting periods
• The error will cause misstated amounts in the
period in which the error occurred, but the
effects will then be counterbalanced by identical
offsetting amounts in the following period
• If ending inventory is understated, retained
earnings in understated
• If ending inventory is overstated, retained
earnings is overstated
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Cutoff Errors and
Inventory Valuation
• Cutoff errors are failures to record transactions
in the correct time period
• Legal transfer of ownership controls the
recording of purchases and sales near the yearend
• The pressure for profits may cause managers to
– Delay the recording of purchases
– Include sales orders in revenues
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The Importance of Gross Profits
• Management and investors are interested in
gross profit and how it changes over time
• Gross profit is often expressed as a percentage
of sales
Gross profit % = Gross profit
Sales
• Wholesalers have smaller gross profit
percentages than retailers
• R&D is treated as a period cost and not a
product cost; thus, pharmaceutical companies
have relatively high gross profit margins
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Estimating Intraperiod Gross Profit
and Inventory
• The gross profit percentage can be used to
estimate ending inventory balances for monthly
or quarterly reports
• Suppose a Home Depot Store has quarterly
sales of $10 million and usually has a gross
profit percentage of 30%. Cost of goods sold
can be estimated as:
Sales – Cost of goods sold = Gross profit
$10M – CGS = .30 x $10M
CGS = $7M
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Estimating Intraperiod Gross Profit
and Inventory
• Also assume the beginning inventory is $5
million and purchases are $7.1 million. Ending
inventory can be estimated as:
Beginning inventory + Purchases – Ending Inventory = CGS
$5M + $7.1M – EI = $7.0M
EI = $5.1M
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Gross Profit Percentage
and Turnover
• Inventory turnover relates sales levels to
inventory levels
• Inventory turnover in the previous Home Depot
example would be:
Turnover = Cost of goods sold / Average inventory
= $7M / $5.05M = 1.4
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Gross Profit Percentage
and Turnover
• Industries with higher gross profit percentages
tend to have lower inventory turnover
• Example: lower turnover for jewelers and drug
manufactures means that they need a higher
gross profit margin to cover the high costs of
selling or research
• Inventory turnover is especially effective in
assessing companies in the same industry
– Higher turnover is associated with greater efficiency
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Gross Profit Percentages and
Accuracy of Records
• The gross profit percentage can be used to
prove the accuracy of the accounting records
• An unusually low percentage may mean the
company has tried to avoid taxes by failing to
record all sales
• Some other factors that may cause a decline in
the percentage are
– Price wars that reduce selling prices
– Shifting of the product mix sold
– Increase in shoplifting or embezzlement
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Internal Control of Inventories
• Inventory shrinkage can result from customer
shoplifting or employee embezzlement
• The best deterrent for shoplifting is an alert
employee at the point of sale
• Retail stores also use:
– Sensitized tags on merchandise
– Surveillance cameras
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Shrinkage in
Perpetual Inventory Systems
• Shrinkage is the difference between the cost of
inventory from a physical count and the
inventory balance in the general ledger
• The journal entries to record shrinkage under a
perpetual inventory system would be:
Inventory shrinkage
Inventory
XXX
XXX
To adjust inventory to its balance per physical count
Cost of goods sold
Inventory shrinkage
XXX
XXX
To transfer inventory shrinkage to cost of goods sold
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Shrinkage in
Periodic Inventory Systems
• A periodic inventory system has no running
balance in the inventory account
• Cost of goods sold automatically includes
inventory shrinkage by virtue of the system
• Shrinkage is much more difficult to isolate in the
periodic system
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