INVENTORIES

AND
COST OF GOODS SOLD
Chapter: 3
 INVENTORY HELD BY BUSINESSES
Retailers and Wholesalers
Purchase inventory in finished form and hold it for resale
Finished Product
Manufacturers
Transform raw materials into a finished product prior to sale.
Raw Materials
Work In Progress (Semi-finished product)
Finished product
 TYPES OF INVENTORY COST
Wholesaler & Retailer:
Purchase cost
Manufactures:
Raw Materials (Direct Materials): Ingredients used in making
a product.
Direct Labor: Paid to workers to manufacture the products.
Manufacturing Overhead: All other costs that are related to the
manufacturing process but cannot be directly matched to specific units
of output. Eg: Depreciation of Factory, Machinery, Salary of factory
accountant etc
 NET SALES OF MERCHANDISE
Sales Revenue
The inflow of either cash or accounts receivable from the sale off a
product.

Two deductions from Sales

Sales returns and allowance
Sales discounts

*Allowance: Cash refund to customers as cost of spoiled or damaged

merchandise

Net Sales: Sales Revenue less sales returns and allowances and sales
discounts.
SALES RETURNS AND
ALLOWANCES
 records inventory returned by customers
who are not completely satisfied
 a customer may be given an allowance for
spoiled or damaged merchandise
 single account used to record both returns
and allowances
CREDIT TERMS AND SALES
DISCOUNTS
n/30 Payment due 30 days from invoice

1/10, n/30 Deduct 1% of invoice amount if

paid within 10 days; otherwise full invoice
amount is due in 30 days
2/10, n/30 Deduct 2% of invoice amount if
paid within 10 days; otherwise full invoice
amount is due in 30 days

n: net amount of the selling price

NET SALES

Sales revenue $103,500

Less: Sales returns and
allowances 2,000
Sales discounts 1,500
Net sales $100,000
THE COST OF GOODS SOLD MODEL
Beginning Purchases of
inventory + merchandise
=
Goods Available
for Sale

Less: Ending inventory

=
Cost
of goods
sold
 THE COST OF GOODS SOLD MODEL

Beginning inventory $ 15,000

+ Cost of goods purchased 63,000
= Cost of goods available for sale 78,000
– Ending inventory (18,000)
= Cost of goods sold $ 60,000

An increase in ending
“Pool” of goods inventory means more
available to sell was bought than sold
during the period
PERPETUAL INVENTORY SYSTEMS

Inventory records are updated after each purchase or sale

Goods purchase: Inventory Dr

Cash / Accounts Payable Cr
Goods Sales: Cash / Accounts Receivable Dr.
Sales Cr.
Cost of goods sold Dr.
Inventory Cr

Perpetual: continuous
 PERIODIC INVENTORY SYSTEMS
Inventory records are not updated each time a sale or purchase is made.
Inventory records are updated periodically based on physical inventory
counts

Goods purchase: Purchase Dr.

Cash / Account Payable Cr.

Goods sales: Cash / Account Receivable Dr.

Sales Cr.

Adjustment at the end of the period:

Inventory Dr.
Purchase Cr.

Reduces record keeping but also decreases the ability to track

theft, breakage, etc., and prepare interim financial statements
COST OF GOODS PURCHASED
 Includes invoice price:

Less:
Purchase returns and
allowances
Purchase discounts

Plus:
Transportation-in
RECORDING PURCHASES

Balance Sheet Income Statement

Assets = Liabilities + Stockholders’ + Revenues -- Expenses
Equity
Accounts Purchases
Payable 4,000 (4,000)

To record purchase of inventory.

RECORDING PURCHASE
RETURNS AND ALLOWANCES

Balance Sheet Income Statement

Assets =
Liabilities + Stockholders’ + Revenues -- Expenses
Equity
Accounts Purchase Returns and
Payable (850)
Allowances 850

To record inventory returned to supplier.

RECORDING PURCHASE DISCOUNTS

Balance Sheet Income Statement

Assets = Liabilities + Stockholders’ + Revenues -- Expenses

Equity
Cash (495) Accounts Purchase
Payable (500) Discounts 5
($ 500 × 1% = $5 discount)

To record payment within discount period to

supplier who offers 1% purchase discount.
EXERCISE: 5-8 PURCHASE DISCOUNTS
For each of the following transactions of Buckeye Corporation, prepare
the appropriate journal entry. (All purchases on credit are made with
terms of 1/10, n/30, and Buckeye uses the periodic system of inventory)
July 3: Purchased merchandise on credit from Wildcat Corp. for
$3,500.00.
July 6: Purchased merchandise on credit from Cyclone Company
for $7,000.
July 12: Paid amount owed to Wildcat Corp.
August 5: Paid amount owed to Cyclone Company.
EXERCISE: 5-6 PURCHASES – PERIODIC
SYSTEM
For each of the following transactions of Wolverine Corporation, prepare the
appropriate journal entry. The company uses the periodic system.
March 3: Purchased merchandise from Spartan Corp. for $2,500 with terms
of 2/10, n/30 Shipping costs of $250 were paid to Neverlate Transit Company.
March 7: Purchased merchandise from Boilermaker Company for $1,400 with
terms of n/30
March 12: Paid amount owed to Spartan Corp.
March 15: Received a credit of $500 on defective merchandise purchased from
Boilermaker Company. The merchandise was kept.
March 18: Purchased merchandise from Gopher Corp. for $1,600 with terms of
2/10. n/30.
March 22: Received credit of $400 from Gopher Corp. for spoiled merchandise
returned to Gopher. This is the amount of credit exclusive of any discount.
April 6: Paid amount owed to Boilermaker Company.
April 18: Paid amount owed to Gopher Corp.
SHIPPING TERMS
AND TRANSPORTATION COSTS
All costs necessary to prepare an asset for its intended use should be
included in its cost.
Invoice Amount XXX
Sales Tax XXX
Transportation XXX
Cost of goods purchased XXX
Terms of Shipment:
FOB destination point or POB shipping point: Responsibility of the
seller to deliver the products to the buyer.
FOB Shipping point: The buyer incurs transportation cost.

FOB stands for “free on board”

FOB DESTINATION POINT

Title passes at destination

 No sale or purchase until inventory reaches its

destination
 Seller responsible for inventory while in transit

FOB stands for “free on board”

FOB SHIPPING POINT

 Both sale and purchase recorded upon shipment

 Buyer responsible for inventory while in transit

Title passes when shipped

ANALYSIS OF PROFITABILITY

Of
particular
interest Gross
to current and Profit %
potential
investors

The Gross Profit Ratio: Dividing gross profit by net sales

Company’s ability to cover operating expenses and earn a profit
DAISY’S PROFITABILITY

Net sales $100,000

Cost of goods sold 60,000
Gross profit $ 40,000

Gross profit ratio = 40%

Gross Profit Ratio = Gross Profit

Net Sales
(How many cents on every $ of sales are left over after covering the
cost of the product)
Indicates a company’s ability to cover operating expenses and earn a
profit.
EXERCISE: 5-10 WORKING BACKWARD:
GROSS PROFIT RATIO
Acme’s gross profit ratio increased by 20%
over the prior year. Net sales and cost of goods
sold for the prior year were $120,000 and
$90,000 respectively. Cost of goods sold for the
current year is $140,000.
Required:
Determine the amount of Acme’s sales for the
current year.
(Answer: $200,000.)
PROBLEM 5-8 PURCHASES AND SALES OF
MERCHANDISE, CASH FLOWS
Two Wheeler, a bike shop, opened for business on April 1. It uses a periodic inventory
system. The following transactions occurred during the first month of business:
April 1: Purchased five units from Duhan Co. for $500 total, with terms 3/10, n/30, FOB
destination
April 10: Paid for April 1 purchase.
April 15: Sold one unit for $200 cash.
April 18: Purchased ten units from Clinton Inc. for $900 total, with terms 3/10, n/30, FOB
destination.
April 25: Sold three units for $ 200 each, cash.
April 28: Paid for the April 18, purchase.
Required
1. For each of the preceding transactions of Two Wheeler, prepare the appropriate journal
entry.
2. Determine net income for the month of April. Two Wheeler incurred and paid $100 for
rent and $50 for miscellaneous expenses during April. Ending inventory is $967. (Ignore
income taxes).
3. Assuming that these are the only transactions during April (including rent and
miscellaneous expenses), compute net cash flow from operating activities.
INVENTORY VALUATION AND
INCOME MEASUREMENT

Value
Value expensed
assigned to When Sold = as cost of
inventory goods sold
on balance on income
sheet statement

The value assigned to an asset such as inventory on the

balance sheet determines the amount eventually recognized as
an expense on the income statement.
INVENTORY VALUATION AND
INCOME MEASUREMENT

Beginning Inventory $ 500

Add; Purchases $1,200 Inventory on
Cost of goods available for sale $1,700 Balance Sheet
Less; Ending Inventory ($ 600)
Cost of goods sold $1,100

Cost of goods sold in

Income Statement

If the ending inventory amount is incorrect, cost of goods sold

will be wrong; thus, the income statement of the period will be
in error as well.
INVENTORY COSTS INCLUDED
 Any freight (transportation) costs incurred by
buyer
 Cost of insurance for inventory in transit
 Cost of storing inventory before selling
 Excise and sales taxes
INVENTORY COSTING
METHODS
Four costing methods available:

Specific Weighted
Identification Average

First-in, First-out Last-in, First-out

(FIFO) (LIFO)
INVENTORY COSTING METHODS
Everett Company purchases merchandise twice during the first year of
business. The dates, number of units purchased, and costs are as follows:
February 4 200 units purchased at $1.00 per unit = $200
October 13 200 units purchased at $1.50 per unit = $300
Everett sold 200 units during the first year can be:

a) 200 units sold at $1.00 each = $200 cost of goods sold

200 units on hand at $1.50 each = $300 ending inventory
b) 200 units sold at $1.50 each = $300 cost of goods sold
200 units on hand at $1.00 each = $200 ending inventory
c) 200 units sold at $1.25 each = $250 cost of goods sold
200 units on hand at $1.25 each = $250 ending inventory
SPECIFIC IDENTIFICATION
METHOD
An Inventory costing method that relies on matching unit
costs with the actual units sold.

Steps
1. Indentify the specific units in inventory at the end of the year and
their cost.
2. Identify the units sold and calculate the cost of goods sold.
3. Calculate the cost of goods available for sale.

Practical difficulty of applying

Not widely used
SPECIFIC IDENTIFICATION
METHOD
Units in ending inventory:
Date purchased Units Cost Total Cost
1/20 100 $11 $ 1,100
4/8 300 12 3,600
9/5 200 13 2,600
Ending inventory 600 $ 7,300

Units × Cost = Total cost

SPECIFIC IDENTIFICATION
METHOD
Date purchased Units Cost Total Cost
Beg. inventory 500 $10 $5,000
1/20 200 11 2,200
4/8 100 12 1,200
12/12 100 14 1,400
Cost of goods sold 900 $9,800

Units × Cost = Total cost

WEIGHTED AVERAGE METHOD
An inventory costing method that assigns the same unit cost
to all units available for sale during the period.

Steps
1. Calculate the cost of goods available for sale.
2. Divide the cost of goods available for sale by the total units to
determine the weighted average cost per unit
3. Calculate ending inventory and cost of goods sold by multiplying
the weighted average cost per unit by the number of units in ending
inventory and the number of units sold.
WEIGHTED AVERAGE METHOD
Step
1. Calculate the cost of goods available for sale.

Date purchased Units Cost Total cost

Beg. inventory 500 $10 $ 5,000
1/20 300 11 3,300
4/8 400 12 4,800
9/5 200 13 2,600
12/12 100 14 1,400
Cost of goods
available for sale 1,500 $17,100
WEIGHTED AVERAGE METHOD
Step
2 Divide the cost of goods available for sale by the total units to
determine the weighted average cost per unit

Weighted average cost per unit =

Cost of Goods Available for Sale

Units Available for Sale

$17,100
1,500

$11.40 per unit

WEIGHTED AVERAGE METHOD

Step 3: Calculate ending inventory and cost of goods sold by

multiplying the weighted average cost per unit by the number
of units in ending inventory and the number of units sold.

Weighted Average Cost X No. of Units

ALLOCATE TO
Ending Cost of
Inventory Goods Sold
Units on hand 600
Units sold 900
Weighted average cost × $11.40 $ 11.40
Total cost of goods
available of $17,100 allocated: $6,840 $10,260
EXERCISE: 5-24 WEIGHTED AVERAGE COST
METHOD AND GROSS PROFIT RATIO
Martin Corp. began the year with 2,000 units of
inventory that had been purchased for $6 per unit.
During the year, 5,000 units were purchased for $8
each and 8,000 units for $10 each. Martin sold 9,000
units during the year for $15 each. The company uses
the weighted average cost method.
Required:
1. Compute cost of goods sold expense.
2. Compute the gross profit ratio.
EXERCISE: 5-25 INVENTORY COSTING
METHOD-PERIODIC SYSTEM
The following information is available concerning the inventory of Carter Inc:
Units Unit Cost
Beginning Inventory 200$10
Purchases:
March 5 30011
June 12 40012
August 23 25013
October 2 15015

During the year, Carter sold 1,000 units. It uses a periodic inventory system.
Required: Calculate ending inventory and cost of goods sold using
Weighted average method.
FIRST-IN, FIRST-OUT (FIFO) METHOD
Assumes that the first units in, or purchased, are the first units out, or
sold.
An Inventory costing method that assigns the most recent costs to ending
inventory.

Steps
1. Assign the cost of the beginning inventory to cost of goods sold.

2. Continue to work forward until you assign the total number of units
sold during the period to cost of goods sold. Allocate the remaining
costs to ending inventory
FIRST-IN, FIRST-OUT (FIFO)
METHOD

Step 1: Assign the cost of the beginning

inventory to cost of goods sold.
FIRST-IN, FIRST-OUT (FIFO) METHOD
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14
FIRST-IN, FIRST-OUT (FIFO)
METHOD

Step 2: Continue to work forward until you assign

the total number of units sold during the period to cost
of goods sold. Allocate the remaining costs to ending
inventory.
FIRST-IN, FIRST-OUT (FIFO)
METHOD
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11 3,300
4/8 300 / 100 $12 $3,600 1,200
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS $7,600 $9,500
EXERCISE: 5-12 INVENTORY COSTING
METHODS
VanderMeer Inc. reported the following information for the month of
February:
Inventory, February 1 65 units @ $20
Purchases:
February 7 50 units @ $22
February 18 60 units @ $23
February 27 45 units @ $24
During February, VanderMeer sold 140 units. The company uses a periodic
inventory system.
Required:
What is the value of ending inventory and cost of goods sold for February
under the following assumptions:
1. Of the 140 units sold, 55 cost $20, 35 cost $22, 45 cost $23, and 5 cost
$24
2. FIFO
PROBLEM 5-11 INVENTORY COSTING METHOD
– PERIODIC SYSTEM
Following is an inventory acquisition schedule for Weaver Corp. for 2012:
Units Unit Cost
Beginning Inventory 5,000 $ 10
Purchase:
February 4 3,000 9
April 12 4,000 8
September 10 2,000 7
December 5 1,000 6
During the year, Weaver sold 12,500 units at $12 each. All expenses except
cost of goods sold and taxes amounted to $20,000. The tax rate is 30%
Required: Compute cost of goods sold and ending inventory under each of
the following two methods assuming a periodic inventory system: (a)
weighted average, b) FIFO
 PERPETUAL SYSTEM
Under the perpetual inventory system, an entity continually
updates its inventory records to account for additions to and
subtractions from inventory for such activities as:
 Received inventory items
 Goods sold from stock
 Items moved from one location to another
 Items picked from inventory for use in the production
process
 Items scrapped
PERPETUAL INVENTORY
SYSTEM
Four costing methods available:

First-in, First-out Weighted

(FIFO) Average

Last-in, First-out
(LIFO)
FIFO COSTING WITH A
PERPETUAL SYSTEM

Same FIFO inventory total under periodic

and perpetual systems
PROBLEM 5-13 COMPARISON OF INVENTORY
COSTING METHODS-PERPETUAL SYSTEM
Bitten Company’s inventory record show 600 units on hand on October 1 with a unit
cost of $5 each. The following transactions occurred during the month of October:

Date Unit Purchases Unit Sales

October 4 500 @ $10.00
8 800 @ $5.40
9 700 @ $10.00
18 700 @ $5.76
20 800 @ $11.00
29 800 @ $5.90
Required:
Prepare a chart comparing cost of goods sold and ending inventory using the perpetual system
and the following costing methods.
Cost of goods sold Ending Inventory Total
Weighted average
FIFO
LIFO
EXERCISE: 5-28 INVENTORY COSTING METHOD-
PERPETUAL SYSTEM
The following information is available concerning stillwater Inc:

Purchases Stillwater, which uses a perpetual

Units Unit system, sold 1,000 units for $ 22
Cost each during the year. Sales
Beginning Inventory 200 $10 occurred on the following dates:
Purchases: Units
March 5 300 $11 February 12 150
June 12 400 $12 April 30 200
August 23 250 $13 July 7 200
October 2 150 $15 September 6 300
December 3 150

Required : Calculate ending inventory and cost of goods sold using

Moving Average Method & FIFO method
 LAST-IN, FIRST-OUT (LIFO) METHOD
Assumes that the last units in, or purchased, are the first units out, or
sold.
Method that assign the most recent costs to cost of goods sold.

Steps:
1. Assign the cost of the last units purchased to cost of goods sold.

2. Work backward until you assign the total number of units sold during
the period to cost of goods sold (allocate the remaining costs to
ending inventory)
LAST-IN, FIRST-OUT (LIFO) METHOD

Step 1: Assign the cost of the last units

purchased to cost of goods sold.
LAST-IN, FIRST-OUT (LIFO)
METHOD
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14 $1,400
LAST-IN, FIRST-OUT (LIFO)
METHOD

Step 2: Work backward until you assign the total

number of units sold during the period to cost of goods
sold (allocate the remaining costs to ending inventory).
LAST-IN, FIRST-OUT (LIFO)
METHOD
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 100 / 200 $11 1,100 $ 2,200
4/8 400 $12 4,800
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS $6,100 $11,000
EXERCISE: 5-12 INVENTORY COSTING
METHODS
VanderMeer Inc. reported the following information for the month of
February:
Inventory, February 1 65 units @ $20
Purchases:
February 7 50 units @ $22
February 18 60 units @ $23
February 27 45 units @ $24
During February, VanderMeer sold 140 units. The company uses a
periodic inventory system.
Required:
What is the value of ending inventory and cost of goods sold for
February under the following assumptions:
LIFO
PROBLEM 5-11 INVENTORY COSTING METHOD
– PERIODIC SYSTEM
Following is an inventory acquisition schedule for Weaver Corp. for 2012:
Units Unit Cost
Beginning Inventory 5,000 $ 10
Purchase:
February 4 3,000 9
April 12 4,000 8
September 10 2,000 7
December 5 1,000 6
During the year, Weaver sold 12,500 units at $12 each. All expenses except
cost of goods sold and taxes amounted to $20,000. The tax rate is 30%
Required: Compute cost of goods sold and ending inventory under each of
the following two methods assuming a periodic inventory system: a) LIFO
LIFO COSTING WITH A
PERPETUAL SYSTEM

Different LIFO inventory total under periodic and perpetual

systems because of pricing gap
PROBLEM 5-13 COMPARISON OF INVENTORY
COSTING METHODS-PERPETUAL SYSTEM
Bitten Company’s inventory record show 600 units on hand on October 1 with a unit
cost of $5 each. The following transactions occurred during the month of October:

Date Unit Purchases Unit Sales

October 4 500 @ $10.00
8 800 @ $5.40
9 700 @ $10.00
18 700 @ $5.76
20 800 @ $11.00
29 800 @ $5.90

Required:
Prepare a chart comparing cost of goods sold and ending inventory using the perpetual system
and the following costing methods.
Cost of goods sold Ending Inventory Total
LIFO
EXERCISE: 5-28 INVENTORY COSTING METHOD-
PERPETUAL SYSTEM
The following information is available concerning stillwater Inc:

Purchases Stillwater, which uses a perpetual

Units Unit system, sold 1,000 units for $ 22
Cost each during the year. Sales
Beginning Inventory 200 $10 occurred on the following dates:
Purchases: Units
March 5 300 $11 February 12 150
June 12 400 $12 April 30 200
August 23 250 $13 July 7 200
October 2 150 $15 September 6 300
December 3 150

Required : Calculate ending inventory and cost of goods sold using

LIFO method
 MOVING AVERAGE METHOD
 The name given to an average cost method when a weighted
average cost assumption is used with a perpetual inventory
system.

 Theaverage cost of each inventory item in stock is re-

calculated after every inventory purchase.

 Endinginventory and Cost of goods sold results are in-

between those derived under the first in, first out (FIFO)
method and the last in, first out (LIFO) method.

 This
averaging approach is considered to yield a safe and
conservative approach to reporting financial results.
DETERMINING ENDING INVENTORY USING
MOVING AVERAGE WITH A PERPETUAL
SYSTEM

Purchases Sales Balance

Date
Units Unit Cost Total Cost Units Unit Cost Total Cost Units Unit Cost Balance
1-Jan 0 0 500 10.00 5000.00
20-Jan 300 11 3300 0 800 10.38 8300.00
18-Feb 0 450 10.38 4668.75 350 10.38 3631.25
8-Apr 400 12 4800 0 750 11.24 8431.25
19-Jun 0 300 11.24 3372.50 450 11.24 5058.75
5-Sep 200 13 2600 0 650 11.78 7658.75
20-Oct 0 150 11.78 1767.40 500 11.78 5891.35
12-Dec 100 14 1400 0 600 12.15 7291.35
PROBLEM 5-13 COMPARISON OF INVENTORY
COSTING METHODS-PERPETUAL SYSTEM
Bitten Company’s inventory record show 600 units on hand on October 1 with a unit
cost of $5 each. The following transactions occurred during the month of October:

Date Unit Purchases Unit Sales

October 4 500 @ $10.00
8 800 @ $5.40
9 700 @ $10.00
18 700 @ $5.76
20 800 @ $11.00
29 800 @ $5.90
Required:
Prepare a chart comparing cost of goods sold and ending inventory using the perpetual system
and the following costing methods.
Cost of goods sold Ending Inventory Total
Weighted average
FIFO
LIFO
EXERCISE: 5-28 INVENTORY COSTING METHOD-
PERPETUAL SYSTEM
The following information is available concerning stillwater Inc:

Purchases Stillwater, which uses a perpetual

Units Unit system, sold 1,000 units for $ 22
Cost each during the year. Sales
Beginning Inventory 200 $10 occurred on the following dates:
Purchases: Units
March 5 300 $11 February 12 150
June 12 400 $12 April 30 200
August 23 250 $13 July 7 200
October 2 150 $15 September 6 300
December 3 150

Required : Calculate ending inventory and cost of goods sold using

Moving Average Method & FIFO method
SELECTING AN
INVENTORY COSTING METHOD
The choice of an inventory method will impact cost of goods sold and
thus net income. A company should choose the method that results in the
most accurate measure of net income for the period.
Cost of Goods
Ending Goods Available
Inventory Sold for Sale

Specific
Identification $7,300 $ 9,800 $17,100
Weighted
Average 6,840 10,260 17,100
FIFO 7,600 9,500 17,100

LIFO 6,100 11,000 17,100

IMPACT OF INVENTORY COSTING
METHOD ON INCOME TAX
During a period of rising prices
LIFO Relative to FIFO
Cost of goods sold Higher Lower
Gross Profit Lower Higher
Income before Taxes Lower Higher
Taxes Lower Higher
EXHIBIT 5-7 INCOME STATEMENTS FOR THE
INVENTORY COSTING METHODS
Weighted Average FIFO LIFO
Sales Revenue - $20 each 18,000 18,000 18,000
Beginning Inventory 5,000 5,000 5,000
Purchases 12,100 12,100 12,100
Cost of goods available for sale 17,100 17,100 17,100
Ending Inventory 6,840 7,600 6,100
Cost of goods sold 10,260 9,500 11,000
Gross Profit 7,740 8,500 7,000
Operating Expenses 2,000 2,000 2,000
Net Income before tax 5,740 6,500 5,000
Income Tax Exp. (40%) 2,296 2,600 2,000
Net Income 3,444 3,900 3,000
INTERNATIONAL ACCOUNTING STANDARD
(IAS 2) – INVENTORIES

The cost of inventories is measured using one of the

following cost formulas:
 Specific identification method
 First-in, first-out (FIFO) method
 Weighted-average cost method

An GAAP in the United States comes closer to

converging with the international standards, it is still
uncertain whether LIFO will survive as an acceptable
inventory valuation method.
LIFO ISSUES
 LIFO liquidation
 The result of selling more units than are purchased during the
period, which have negative tax consequences (effects).
 Liquidation can result in high gross profit (and large tax bill)
 LIFO conformity rule
 FIFO to report its income to stockholders, maximizing the
amount of net income.
 LIFO to report to the tax office, minimizing its taxable income.
 If used for tax, LIFO must also be used for books
 LIFO reserve
 The excess of the value of a company’s inventory stated at
FIFO over the value stated at LIFO.
 Approximate the tax saving to the company from the use of
LIFO
 COSTING METHODS AND INVENTORY PROFITS
FIFO, LIFO, and Weighted Average are all cost-based methods to
value inventory.
Replacement cost: The current cost of a unit of inventory
Inventory profit: The portion of the gross profit that results from
holding inventory during a period of rising prices.

Sales revenue (900 units X $20) $18,000.00

Cost of goods sold-FIFO basis $ 9,500.00
Gross Profit $ 8,500.00
Cost of goods sold-replacement cost basis: $13,500
Cost of goods sold – FIFO basis; $ 9,500
Profit from holding inventory during a period of inflation $ 4,000.00
Gross profit on a replacement cost basis $4,500.00
INVENTORY ERRORS
Ending Inventory: Overstated
Cost of goods sold: Understated
Net Income: Overstated

Ending Inventory: Understated

Cost of goods sold: Overstated
Net income: Understated
REASONS OF ERRORS
 Mathematical mistakes
 Physical inventory counting errors
 Cutoff problems – in-transit
FOB Shipping point
EFFECT OF INVENTORY ERRORS ON
THE INCOME STATEMENT, 2012
Reported Corrected Effect
Sales $1,000,000 $1,000,000
Beginning inventory $ 200,000 $ 200,000
Add: Purchases 700,000 700,000
Goods available for sale $ 900,000 $ 900,000
Less: Ending inventory 300,000 250,000 $50 OS
Cost of goods sold $ 600,000 $ 650,000 50 US
Gross margin $ 400,000 $ 350,000 50 OS
Operating expenses 100,000 100,000
Net income $ 300,000 $ 250,000 50 OS

OS = overstatement OS = Overstatement
US = understatement US= Understatement
EFFECT OF INVENTORY ERRORS
ON THE INCOME STATEMENT, 2013
Reported Corrected Effect
Sales $1,500,000 $1,500,000
Beginning inventory $ 300,000 $ 250,000 $50 OS
Add: Purchases 1,100,000 1,100,000
Goods available for sale $1,400,000 $1,350,000 50 OS
Less: Ending inventory 350,000 350,000
Cost of goods sold $1,050,000 $1,000,000 50 OS
Gross margin $ 450,000 $ 500,000 50 US
Operating expenses 120,000 120,000
Net income $ 330,000 $ 380,000 50 US
OS = overstatement
US = understatement
COUNTERBALANCING ERRORS
Assume ending inventory is overstated (+) by
$50,000 in 2012:
2012
Beginning inventory xxx,xxx
Add: Purchases xxx,xxx
= Goods available for sale xxx,xxx
Less: Ending inventory +50,000
= Cost of goods sold –50,000

The effects of errors in inventory may offset themselves over time.

These are known as counterbalancing errors
COUNTERBALANCING
ERRORS
2012 ending inventory becomes 2013 beginning
inventory:
2012 2013
Beginning inventory $xxx,xxx +50,000
Add: Purchases xxx,xxx
= Goods available for sale xxx,xxx
Less: Ending inventory +50,000
= Cost of goods sold –50,000
COUNTERBALANCING
ERRORS
The 2012 error reverses in 2013 (but 2012 inventory
both 2012 and 2013 profits are misstated by 50,000):
2012 2013
Beginning inventory $xxx,xxx $+50,000
Add: Purchases xxx,xxx xxx,xxx
= Goods available for sale xxx,xxx +50,000
Less: Ending inventory +50,000 xxx,xxx
= Cost of goods sold
–50,000 +50,000
LOWER OF COST OR MARKET
The lower of cost or market rule is a departure from the historical cost principle. Accounting
standards require the inventory be written down at the end of the period if the market value of
the inventory is less than its cost.

Cost Market Price Price

Cost $100 $80

Loss on Decline in value of Inventory XXX

Report loss
Inventory XXX
in year
To record decline in value of Inventory market falls
below cost…
The entry reduces assets in the form of inventory and net income.

Historical cost principle which says that assets should be carried on the balance sheet
at their original cost.
LOWER OF COST OR MARKET
 Market = replacement cost (not retail value)
 Cost determined under one of the costing methods
 Justified on basis of conservatism
 Can be applied to:
 Entire inventory
 Individual items (Most popular)
 Groups of items

Accounting conservatism will recognize all probable losses as they are

discovered and most expenditures as they are incurred. Revenue will be
deferred until it is verified. Having strict revenue-recognition criteria is
one of the most common forms of accounting conservatism.
ANALYZING THE MANAGEMENT OF
INVENTORY
A company’s ability to sell its inventory quickly can
be measured by computing the inventory turnover
ratio. How often a company sells its inventory during
a period is found by dividing cost of goods sold by
average inventory.

Inventory Turnover ratio =

Cost of goods sold
Average Inventory
It is measure of the number of times inventory is sold during the period.
 INVENTORY TURNOVER RATIO
Gaps Inc.
Income Statement
Balance Sheet
Fiscal Year Fiscal Year
2010 2009 2010 2009
Net Sales 14,664 14,197 Current Assets:
COGS 8,775 8,473 Inventory 1,620 1,477

Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory

= 8,775/ (1620 +1477)/2 = 5.7 times

No. of day’s sales in Inventory
= No. of days in the period/Inventory Turnover ratio
= 360/5.70 = 63 days.
 STATEMENT OF CASH FLOWS
Direct Method
Operating Activities
Deduction: Cash paid to suppliers of inventory

Indirect Method
Operating Activities
Deduction: Increase in Inventory
Addition: Decrease in Inventory
Addition:Increase in Account Payable
Deduction: Decrease in Account Payable
STATEMENT OF CASH FLOWS
Cash Flows from Operating Activities:
Net income xxx
Increase in inventory –
Decrease in inventory +
Increase in accounts payable +
Decrease in accounts payable –

- OR - Direct
Indirect
Method Method

Cash paid for inventory purchases –

END OF CHAPTER 3