Inventories and Cost of Sales

Dr Winston Kwok

Learning Objectives
1. Identify the costs of inventory
2. Compute the inventory in a perpetual system
using the methods of specific identification,
FIFO, and weighted average cost
3. Analyze the effects of inventory methods for
both financial and tax reporting
4. Compute the lower of cost and net realizable
value of inventory
5. Analyze the effects of inventory errors on
current and future financial statements
Identify the costs of inventory
 INVENTORIES

Products a company owns and expects

to sell in its normal operations.

Merchandisers

Manufacturer Wholesaler Retailer Consumers

 DETERMINING INVENTORY COSTS
Include all expenditures necessary to bring an item to
a salable condition and location.

Minus
Discounts Invoice Plus
Storage
and
Allowances
Cost

Plus Import Plus

Duties Plus Insurance
Freight
 INVENTORIES
Defined according to type and nature of the company.

Merchandiser:
Items to be resold.
For a supermarket, food is
inventory, the shopping trolley is not.
 INVENTORIES
Defined according to type and nature of the company.

Manufacturer:
Raw materials
Goods acquired in a relatively undeveloped state.
Eventually will compose a major part of the finished
product.
Work in process (WIP)
Partly finished products.
Manufacturing plant contains work in process
inventory.
Finished goods
Completed products waiting for sale.
 INVENTORIES AND COST OF SALES

Merchandise or Beginning Net

= +
cost of goods inventory purchases
available for sale

Merchandise or
At end of period, cost of goods is allocated between
available for sale
inventory still remaining (a current asset on
statement of financial position), and
inventory sold during the period (an operating
expense called cost of sales or cost of goods sold
on the income statement).
 COST OF GOODS SOLD (COST OF SALES)

Represents net purchase costs of inventory sold to

customers during accounting period.
Cost of goods sold =
beginning inventory + net purchases ending inventory
Often the largest expense for a manufacturer or a
merchandiser.
 GROSS PROFIT (GROSS MARGIN)

Difference between net sales and

cost of sales.

Gross Profit = Net Sales Cost of Sales

Must keep this high as it must cover

all other expenses to generate net
profit.
 INCOME STATEMENTS
Service Company Merchandising Company
Income Statement Income Statement
For Year Ended December 31 For Year Ended December 31

Service revenue $200 Sales $200

Expenses Cost of goods sold 55
Salary expense 80 Gross profit 145
Depreciation expense 25 Expenses
Income tax expense 10 Salary expense 80
Net income $ 85 Depreciation expense 25
Income tax expense 10
Net income $ 30
 STATEMENTS OF FINANCIAL POSITION
Service Company Merchandising Company
Statement of Financial Position Statement of Financial Position
December 31 December 31

Current assets Current assets

Cash $300 Cash $300
Accounts receivable 600 Accounts receivable 600
Prepaid expenses 80 Inventories 700
Total current assets $980 Prepaid expenses 80
Total current assets $1,680
 SAMSUNGS INVENTORIES

Inventories 3rd largest current asset

 SAMSUNGS INVENTORIES

Breakdown of
inventories
SAMSUNGS INVENTORIES

Gross profit as
a percent of revenue = 38%
COMPETITORS COMPARISON

Source: www.gurufocus.com
Compute the inventory in a perpetual system
using the methods of specific identification,
FIFO, and weighted average cost
 OPERATING CYCLE FOR A
MERCHANDISER
Begins with the purchase of merchandise
and ends with the collection of cash from the
sale of merchandise.
 INVENTORY SYSTEMS

Perpetual systems Periodic systems

continually update accounting records
accounting records for relating to inventory
inventory transactions transactions are
updated only at the end
of the accounting period
(not covered in ACC1002)
Most companies take a physical count of inventory at
least once each year.
 INVENTORY COSTING UNDER
A PERPETUAL SYSTEM

Inventory
affects . . .
Statement
of Income
Financial Statement
Position

The matching
principle requires
matching costs
with sales.
 MERCHANDISE PURCHASES
On November 2, Z-Mart purchased $1,200 of
merchandise inventory for cash.
 SALES OF MERCHANDISE

Each sales transaction for a seller of

merchandise involves two parts:

Revenue received in Recognition of the

the form of an asset cost of merchandise
from a customer. sold to a customer.
 SALES OF MERCHANDISE

On November 3, Z-Mart sold $2,400 of

merchandise on credit. The merchandise has a
cost basis to Z-Mart of $1,600.
 INVENTORY COST METHODS
When inventory items are purchased at different
costs, a question arises as to which amounts to
record in COGS and which amounts remain in
inventory.
Cost methods assume particular patterns for how
costs flow through inventory.
Physical flow and cost flow need not be the same.
Methods allowed under IFRS (IAS 2 Inventories):
specific identification, FIFO, and weighted average
cost.
 INVENTORY COSTING ILLUSTRATION
Here is information about the mountain bike inventory of Trekking
for the month of August.
 SPECIFIC IDENTIFICATION

Can be used when each item in inventory can be identified

with a specific purchase and invoice.
Specific identification is usually practical only for
companies with expensive, custom-made inventory.
 SPECIFIC IDENTIFICATION

* Identification of items sold (and their costs) is obtained from internal documents
that track each unit from its purchase to its sale.
 SPECIFIC IDENTIFICATION

Income Statement
Cost of Goods Sold Statement of Financial Position
Inventory
 SPECIFIC IDENTIFICATION
Here are the entries to record the purchases and sales. The COGS
(numbers in red) are determined by the cost method used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
Aug. 14 $130
Aug. 31 150
 INVENTORY COST METHODS

First-In, First-Out Assumes costs flow in the order

(FIFO) incurred.

Weighted Assumes costs flow at an

Average Cost average of the costs available.
FIRST-IN, FIRST-OUT (FIFO)

Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory
 FIRST-IN, FIRST-OUT (FIFO)

20 units sold on Aug 14: FIFO assumes 10 units from beginning balance and
another 10 from Aug 3 purchase.
 FIRST-IN, FIRST-OUT (FIFO)

23 units sold on Aug 31: FIFO assumes 5 units from Aug 3 purchase and
another 18 from Aug 17 purchase.
 FIRST-IN, FIRST-OUT (FIFO)
Here are the entries to record the purchases and sales. The COGS
(numbers in red) are determined by the cost method used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
Aug. 14 $130
Aug. 31 150
 LAST-IN, FIRST-OUT (LIFO)

Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory

This method allowed under US GAAP but not under IFRS

Not examinable in ACC1002
WEIGHTED AVERAGE COST
When a unit is sold, the average
cost of each unit in inventory is
assigned to cost of goods sold.
Cost of Goods Units on hand
Available for on the date of
Sale sale
WEIGHTED AVERAGE COST
WEIGHTED AVERAGE COST
 WEIGHTED AVERAGE COST
Here are the entries to record the purchases and sales. The COGS
(numbers in red) are determined by the cost method used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
Aug. 14 $130
Aug. 31 150
 CONSISTENCY IN USING
COSTING METHODS

Comparability is an enhancing qualitative characteristic

in IASBs Conceptual Framework.
Related to comparability is consistency, which requires
a company to use the same accounting methods period
after period so that financial statements are
comparable across periods.
Change is allowed if that will improve financial reporting
but company must disclose reasons and impact of
change.
Company can use different methods for different
categories of inventory.
Analyze the effects of inventory methods for
both financial and tax reporting
 INVENTORY COSTING ILLUSTRATION
Lets revisit the information about the mountain bike inventory of
Trekking for the month of August.

Costs are rising

 FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Because costs change, inventory methods nearly always
assign different amounts.

In times of rising costs,

FIFO yields higher
gross profit than WAC
 FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS

Since inventory costs affect income, they have potential tax effects.
Trekking can gain a temporary tax advantage by using WAC.
In some countries, companies can and often do use different costing
methods for financial reporting and tax reporting.
FINANCIAL STATEMENT EFFECTS
OF INVENTORY METHODS

Advantages of Methods

Weighted
Average FIFO
Cost

Ending inventory
Smoothes out
approximates
cost changes.
current cost.
 Profit Effects when
Inventory Costs are Increasing

Ending inventory, gross profit, and net profit

FIFO
Weighted
average
 Profit Effects when
Inventory Costs are Decreasing

Ending inventory, gross profit, and net profit

Weighted
average
FIFO
 Compute the lower of cost and
net realizable value of inventory
 GOODS DAMAGED OR OBSOLETE

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.
Cost should be reduced to net realizable
value if they cannot be sold.
Net realizable value is the estimated
selling price in the ordinary course of
business less the estimated costs of
completion and the estimated costs
necessary to make the sale.
 LOWER OF COST AND NET REALIZABLE VALUE
IAS 2: Inventory must be reported at NRV
when NRV is lower than cost.

NRV is the estimated

Can be applied two ways:
selling price in the ordinary
(1) separately to each
course of business less the
individual item.
estimated costs of
(2) to major categories of
completion and the
assets.
estimated costs necessary
to make the sale.
 LOWER OF COST AND NRV
A motor sports retailer has the following
items in inventory:
Per Unit
Units on
Inventory Items Hand Cost NRV Total Cost Total NRV
Cycles:
Roadster 20 $ 8,000 $ 7,000 $ 160,000 $ 140,000
Sprint 10 5,000 6,000 50,000 60,000
Off-Road
Trax-4 8 5,000 6,500 40,000 52,000
Blazer 5 9,000 7,000 45,000 35,000
Totals $ 295,000
 LOWER OF COST AND NRV
Here is how to compute lower of cost and
NRV for individual inventory items.

Lower of Cost and

NRV Applied to
Units on
Inventory Items Hand Total Cost Total NRV Items
Cycles:
Roadster 20 $ 160,000 $ 140,000 $ 140,000
Sprint 10 50,000 60,000 50,000
Off-Road
Trax-4 8 $ 40,000 $ 52,000 40,000
Blazer 5 45,000 35,000 35,000
Totals $ 295,000 $ 265,000
 to
Units on
Inventory Items Hand Total Cost Total NRV Items
Cycles: LOWER OF COST AND NRV
Roadster 20 $ 160,000 $ 140,000 $ 140,000
Lower of Cost
Sprint 10 50,000 60,000 and NRV50,000
Applied
Off-Road to
Trax-4 Units on8 $ 40,000 $ 52,000 40,000
Inventory Items
Blazer Hand 5 Total45,000
Cost Total NRV
35,000 Items
35,000
Cycles:
Totals $ 295,000 Units on $ 265,000
Roadster 20 $ 160,000
Inventory Items $ 140,000
Hand $Total140,000
Cost Tota
Sprint 10 50,000 60,000 50,000
Cycles:
Off-Road Roadster 20 $ 160,000 $ 14
Trax-4 8 $ 40,000 $ 52,000
Sprint 10 40,000
50,000 6
Blazer 5 45,000 35,000 35,000
Off-Road
If this adjusting journal
Totals entry NOT recorded,
$ 295,000 $ 265,000
Trax-4 8 $ 40,000 $ 5
then both profitBlazer
and asset overstated 5
which
45,000 3
will misleadTotals
investors and creditors. $ 295,000
SAMSUNGS INVENTORIES
Analyze the effects of inventory errors on
current and future financial statements
 FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS

How do errors in ending inventory affect

key financial numbers such as:
Cost of goods sold?
Gross profit?
Net income?
Current assets and total assets?
Equity?
 FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS

An error in inventory
results in COGS
being overstated or
understated. Any uncorrected
The inventory error error will affect the
financial statements
has the opposite
for two years.
effect on gross profit
and net income.
 FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS

Ending inventory errors

impact TWO periods
financial statements. 2010
Current period
Ending inventory
Next period
2011
Beginning inventory
Error counterbalanced
by end of second period.
 ENDING INVENTORY UNDERSTATED
Assume that this company errs in computing its 2010 ending inventory and
reports $16,000 instead of the correct amount of $20,000.

Inventory Error Cost of Goods Sold Net Income

Understate ending inventory Overstated Understated
 ENDING INVENTORY UNDERSTATED

Inventory Error Cost of Goods Sold Net Income

Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
ENDING INVENTORY UNDERSTATED
 FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS
Income Statement Effects

Inventory Error Cost of Goods Sold Net Income

Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated

Statement of Financial Position Effects

Inventory Error Assets Equity

Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated
 ETHICS IN BUSINESS
Pressure to report profits
Managements bonuses linked to gross profit
or net income
Shareholders expectations
Analysts forecasts
 ETHICS IN BUSINESS

Management of companies which profits

do not meet shareholders expectations
are sometimes tempted to cook the
books to increase reported profit.

1. Creating fictitious sales revenue

2. Overstating ending inventory
 ETHICS IN BUSINESS
Overstating ending inventory