Reporting and Interpreting Cost of

Goods Sold and Inventory

Chapter 07

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin
7-1

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

Primary
Primary Goals
Goals of
of
Inventory
Inventory
Management
Management

Provide
Provide sufficient
sufficient
quantities
quantities of
of highhighquality
quality inventory.
inventory.

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

7-2

Items Included in Inventory

Inventory

Tangible

Held for Sale

Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory
7-3

Used to
Produce
Goods or
Services

Costs Included in Inventory Purchases

The cost principle requires that inventory
be recorded at the price paid or the
consideration given.

7-4

Invoice
Price

Freight

Inspection
Costs

Preparation
Costs

Flow of Inventory Costs

Merchandiser
Merchandise
Merchandise
Purchases
Purchases
Manufacturer
Raw
Raw
Materials
Materials
Direct
Direct
Labor
Labor
Factory
Factory
Overhead
Overhead
7-5

Merchandise
Merchandise
Inventory
Inventory

Raw
Raw Materials
Materials
Inventory
Inventory

Work
Work in
in Process
Process
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

Finished
Finished Goods
Goods
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

Nature of Cost of Goods Sold

Beginning
Beginning
Inventory
Inventory

Purchases
Purchases
for
for the
the Period
Period

Goods
Goods Available
Available
for
for Sale
Sale

Ending
Ending Inventory
Inventory
(Balance
(Balance Sheet)
Sheet)

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

Beginning
Beginning inventory
inventory ++ Purchases
Purchases == Goods
Goods Available
Available for
for Sale
Sale
Goods
Goods Available
Available for
for Sale
Sale Ending
Ending inventory
inventory == Cost
Cost of
of goods
goods sold
sold
7-6

Inventory Costing Methods

Inventory Costing Methods
1. Specific Identification
2. First-in, First-out
3. Last-in, First-out
4. Weighted Average
Total
Total Dollar
Dollar Amount
Amount of
of Goods
Goods
Available
Available for
for Sale
Sale

Inventory Costing
Method

Ending
Ending Inventory
Inventory
7-7

Cost
Cost of
of Goods
Goods Sold
Sold

Specific Identification

When
When units
units are
are
sold,
sold, the
the
specific
specific cost
cost of
of
the
the unit
unit sold
sold is
is
added
added to
to cost
cost of
of
goods
goods sold.
sold.
7-8

Cost Flow Assumptions

The choice of an inventory
costing method is not based
on the physical flow of goods
on and off the shelves.

FIFO
LIFO
7-9

Weighted
Average

First-In, First-Out Method

7-10

Oldest Costs

Cost of
Goods Sold

Recent Costs

Ending
Inventory

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

7-11

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

Total

5.25

$ 5,250.00

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

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.

First-In, First-Out
Given Information
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

Cost of Goods
Sold

Units

$ 6,695 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.
7-12

First-In, First-Out
Given Information
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
$ 6,695 Cost

Cost of Goods
Sold
1,000 @ $ 5.25
50 @ 5.30

1,050 Units
$ 5,515 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost
to
to all
all 1,050
1,050 units
units sold.
sold.
7-13

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

6,695.00

Cost of
Goods Sold

1,050

5,515.00

7-14

Here is the
cost of
ending
inventory
and cost
of goods
sold using
FIFO.

Last-In, First-Out Method

7-15

Oldest Costs

Ending
Inventory

Recent Costs

Cost of
Goods Sold

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

Total

5.25

$ 5,250.00

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

7-16

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.

Last-In, First-Out
Given Information
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

Cost of Goods
Sold

Units

$ 6,310 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.
7-17

Last-In, First-Out
Given Information
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
$ 6,310 Cost

Cost of Goods
Sold
300
300
250
200
1,050

@ $ 5.30
@ 5.60
@ 5.80
@ 5.90
Units

$ 5,900 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost
to
to all
all 1,050
1,050 units
units sold.
sold.
7-18

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

6,310.00

Cost of
Goods Sold

1,050

5,900.00

7-19

Here is the
cost of
ending
inventory
and cost of
goods sold
using LIFO.

Average Cost Method

When
When aa unit
unit is
is sold,
sold, the
the
average
average cost
cost of
of each
each unit
unit
in
in inventory
inventory is
is assigned
assigned
to
to cost
cost of
of goods
goods sold.
sold.
Cost of Goods
Available for
Sale

7-20

Number of
Units
Available for
Sale

Average Cost Method

1,050 $ 5.42667
7-21

Comparison of Methods

7-22

Financial Statement Effects of Costing

Methods
Advantages of Methods

7-23

First-In,
First-Out

Last-In,
First-Out

Weighted
Average

Ending
Ending inventory
inventory
approximates
approximates
current
current
replacement
replacement cost.
cost.

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

Smoothes
Smoothes out
out
price
price changes.
changes.

International Perspective
LIFO and International Comparisons
While U.S. GAAP allows companies to choose between FIFO,
LIFO, and weighted average inventory methods, International
Financial Reporting Standards (IFRS) currently prohibit the
use of LIFO.
GAAP allows different
inventory accounting
methods to be used for
different types of inventory
items.

7-24

IFRS requires that the

same method be used for
all inventory items that have
a similar nature and use.

These differences can create comparability problems when

one attempts to compare companies across international
borders.

Managers Choice of Inventory Methods

Net
Net Income
Income Effects
Effects
Managers
Managers prefer
prefer to
to report
report
higher
higher earnings
earnings for
for their
their
companies.
companies.

Income
Income Tax
Tax Effects
Effects
Managers
Managers prefer
prefer to
to pay
pay the
the
least
least amount
amount of
of taxes
taxes
allowed
allowed by
by law
law as
as late
late as
as
possible.
possible.

LIFO Conformity Rule

If last-in, first-out is used on the
income tax return, it must also be used
to calculate inventory and cost of
goods sold for financial statements.
7-25

Valuation at Lower of Cost or Market

Ending
Ending inventory
inventory is
is reported
reported at
at the
the
lower
lower of
of cost
cost or
or market
market (LCM).
(LCM).
Replacement
Replacement Cost
Cost
The
The current
current purchase
purchase
price
price for
for identical
identical goods.
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.
7-26

Valuation at Lower of Cost or Market

(1,000 Intel chips $50) = $50,000

7-27

Inventory Turnover
Cost of Goods Sold
Inventory
=
Turnover
Average Inventory

Average
Average Inventory
Inventory is
is .. .. ..

(Beginning
(Beginning Inventory
Inventory ++ Ending
Ending Inventory)
Inventory) 22
This
This ratio
ratio reflects
reflects how
how many
many times
times
average
average inventory
inventory was
was produced
produced and
and
sold
sold during
during the
the period.
period. A
A higher
higher ratio
ratio
indicates
indicates that
that inventory
inventory moves
moves more
more
quickly
quickly thus
thus reducing
reducing storage
storage and
and
obsolescence
obsolescence costs.
costs.
7-28

Inventory and Cash Flows

Add Decrease in Inventory

Increase in Accounts
Payable
Net Income

Increase in Inventory
Decrease in Accounts
Subtract
Payable
7-29

Cash Flows
from
Operations

Inventory Methods and Financial

Statement Analysis
U.S. public companies using LIFO also report beginning and ending
inventory on a FIFO basis in the financial statement notes if the
FIFO values are materially different.

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)

Beginning LIFO Reserve

- Ending LIFO Reserve
Difference in COGS Under FIFO
7-30

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.
7-31

Perpetual and Periodic Inventory

Systems

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

Perpetual
Perpetual
System
System
Provides
Provides up-to-date
up-to-date
cost
cost of
of sales
sales records.
records.
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.
7-32

Perpetual and Periodic Inventory

Systems
Inventory System
Periodic System
Carried over
Beginning Inventory
from prior period
Accumulated in
Add: Purchases
the Purchases
account
Measured at end
of period by
Less: Ending Inventory
physical
inventory count
Computed as a
residual amount
Cost of Goods Sold
at end of period
Item

7-33

Perpetual System
Carried over from
prior period
Accumulated in
the Inventory
account
Perpetual record
updated at every
sale
Measured at
every sale based
on perpetual
record

Errors in Measuring Ending Inventory

Errors in Measuring Inventory
Ending Inventory

Beginning Inventory

Overstated Understated Overstated Understated

Effect on Current Period's Balance Sheet
Ending Inventory
Retained Earnings

+
+

N/A

N/A

N/A

N/A

+
+

+
-

+
+
-

+
+

Effect on n Current Period's Income Statement

Goods Available for Sale
Cost of Goods Sold
Gross Profit
Net Income

7-34

Supplement A: 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.
7-35

Supplement B: Additional Issues in

Measuring Purchases
Purchase returns and
allowances are a reduction
in the cost of purchases
associated with
unsatisfactory goods.

A purchase discount is
a cash discount
received for prompt
payment of an account.
7-36

Supplement B: Additional Issues in

Measuring Purchases
Credit Period

Terms

Discount Period

Time
Due

Full amount
less discount

2/10,n/30

Purchase or Sale

7-37

Full amount due

Discount
Discount
Percent
Percent

Number
Number of
of
Days
Discount
Days Discount
Is
Is Available
Available

Credit
Credit
Period
Period

Supplement C: Comparison of
Perpetual and Periodic Inventory
Systems
Perpetual Inventory System

7-38

Supplement C: Comparison of
Perpetual and Periodic Inventory
Systems
Periodic Inventory System

7-39

End of Chapter 07

7-40