Week 5: Chapter 5 & 6

IN V E N T O R IE S A N D CO S T OF
SA L E S

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
Winston Kwok, Ph.D., CA
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.
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1. Accounting for Merchandising Operations

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OP E R AT IN G CY C L E F O R A
ME R C H A N D IS E R
Begins with the purchase of merchandise
and ends with the collection of cash from the
sale of merchandise.
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TH E FL O W O F IN V E N T O R Y
CO S T S
BALANCE SHEET

Purchase costs (or

Asset
manufacturing Inventory
costs)
as goods are
INCOME STATEMENT sold

Revenue
Cost of goods sold
Gross profit
Expenses
Net income
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IN V E N T O R Y SY S T E M
! Perpetual system: continually update accounting
records for merchandising transactions
!More effective inventory management
!Allow company to detect the amount of inventory loss incurred due
to waste, theft or other loss
!Used for all types of goods.

! Periodic system: accounting records relating to

merchandise transactions are updated only at the
end of the accounting period
!Does not keep a running record of all goods bought and sold. Hard
to detect inventory shrinkage (e.g., theft, spoilage) as well as
management fraud.
!Used for inexpensive goods.
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CO S T OF GO O D S SO L D
" Sellingmerchandise introduces a new and major
cost of doing business: the cost incurred by
merchandising companies to acquire the
inventory they sold to customers. We call it Cost
of goods sold.

" Cost
of Goods Sold is presented as a separate
expense item on the income statement.
 6-7

ME R C H A N D IS IN G CO M PA N Y
" How do a merchandiser’s financial statements differ from
the statement of a service business?
" Balance sheet:
!Merchandiser has inventory, an asset.
!Service business has no inventory
" Income statement:
Merchandiser: Service business:
Sales revenue Service revenue
-Cost of goods sold - Expenses
=Gross profit = Net income
-Operation Expenses
=Net income
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2. Accounting for Purchases and Sales

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ME R C H A N D IS E PU R C H A S E S
On November 2, Z-Mart purchased $1,200 of
merchandise inventory for cash.
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TR A D E DIS C O U N T S
Used by manufacturers and wholesalers
to offer better prices for greater
quantities purchased.

Example
Z-Mart offers a 30% trade
discount for orders of 1,000
units or more on its popular
product Racer. Each
Racer has a list price of $5.25.
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AC C O U N T IN G F O R ME R C H A N D IS E
PU R C H A S E S
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PU R C H A S E DIS C O U N T S

A deduction from the invoice price granted to

induce early payment of the amount due.
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PU R C H A S E DIS C O U N T S

2/10,n/30
Number of
Days Otherwise,
Discount Discount Is Net (or All) Credit
Percent Available Is Due in 30 Period
Days
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PU R C H A S E DIS C O U N T S

On November 2, Z-Mart purchased $1,200 of

merchandise inventory on account, credit
terms are 2/10, n/30.
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PU R C H A S E DIS C O U N T S

On November 12, Z-Mart paid the amount

due on the purchase of November 2.
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PU R C H A S E DIS C O U N T S

After we post these entries, the accounts involved

look like these:
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PU R C H A S E RE T U R N S AND
AL L O W A N C E S

Purchase Return . . .
Merchandise returned by the purchaser to
the supplier.
Purchase Allowance . . .
A reduction in the cost of defective or
unacceptable merchandise received by a
purchaser from a supplier.
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PU R C H A S E RE T U R N S AND
AL L O W A N C E S

On November 15, Z-Mart (buyer) issues a

$300 debit memorandum for an allowance
from Trex for defective merchandise.
 PU R C H A S E RE T U R N S
6 - 19
AND
AL L O W A N C E S

Z-Mart purchases $1,000 of merchandise on June 1 with

terms 2/10, n/60. Two days later, Z-Mart returns $100 of
goods before paying the invoice. When Z-Mart later pays on
June 11, it takes the 2% discount only on the $900
remaining balance.
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TR A N S P O R TAT IO N CO S T S A N D
OW N E R S H IP TR A N S F E R
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TR A N S P O R TAT IO N CO S T S

Z-Mart purchased merchandise on terms of FOB

shipping point. The transportation charge is $75.
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AC C O U N T IN G F O R
ME R C H A N D IS E
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SA L E S OF ME R C H A N D IS E

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.
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SA L E S OF ME R C H A N D IS E

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

merchandise on credit. The merchandise has a
cost basis to Z-Mart of $1,600.
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SA L E S DIS C O U N T S

Sales discounts on credit sales can benefit a seller by

decreasing the delay in receiving cash and reducing future
collection efforts.
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SA L E S DIS C O U N T S
Z-Mart completes a $1,000 credit sale with terms of 2/10, n/60.

The account was paid in full within the 60-day period.

The account was paid in full within the 10-day discount period.
 6 - 27

SA L E S RE T U R N S A N D
AL L O W A N C E S

Sales returns and allowances usually involve

dissatisfied customers and the possibility of
lost future sales.

Sales allowances
Sales returns refer to
refer to reductions in
merchandise that
the selling price of
customers return to
merchandise sold to
the seller after a sale.
customers.
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SA L E S RE T U R N S A N D
AL L O W A N C E S

Recall Z-Mart s sale for $2,400 that had a cost

of $1,600. Assume the customer returns part of
the merchandise. The returned items sell for
$800 and cost $600.
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SA L E S AL L O W A N C E S

Assume that $800 of the merchandise Z-Mart

sold on November 3 is defective but the buyer
decides to keep it because Z-Mart offers a
$100 price reduction.
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PA R T IA L IN C O M E STAT E M E N T
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ME R C H A N D IS IN G CO S T FL O W IN T H E
AC C O U N T IN G CY C L E
Beginning Net
inventory purchases
Period 1

Merchandise
available for sale

Ending Cost of
inventory goods sold To Income Statement
To Balance Sheet
Beginning Net
inventory purchases
Period 2

Merchandise
available for sale

Ending Cost of
inventory goods sold To Income Statement
To Balance Sheet
 6 - 32

AD J U S T IN G EN T R IE S F O R
ME R C H A N D IS E R S
A merchandiser using a perpetual inventory system is
usually required to make an adjustment to update the
Merchandise Inventory account to reflect any loss of
merchandise, including theft and deterioration.

Z-Mart s Merchandise Inventory account at the end of

year 2011 has a balance of $21,250, but a physical
count reveals that only $21,000 of inventory exists.
 6 - 33

CL O S IN G EN T R IE S F O R
ME R C H A N D IS E R S
 6 - 34

IN C O M E STAT E M E N T

An income
statement
format shows
net sales and
other
costs and
expenses.
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3. Measurement of Inventories
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DEFINITION OF INVENTORY
" "Inventories" are assets:
!held for sale in the ordinary course of business;
!in the process of production for such sale; or
!in the form of materials or supplies to be consumed
in the production process or in the rendering of
services.

" HKAS 2 prescribes the accounting treatment for

inventories
 6 - 37

AC C O U N T IN G F O R IN V E N T O R Y

Management decisions in accounting for inventory

involve the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
5. Impact of inventory errors on financial statement
 6 - 38

DE T E R M IN IN G IN V E N T O R Y IT E M S
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment
 6 - 39

GO O D S IN TR A N S IT
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

 6 - 40

GO O D S ON CO N S IG N M E N T
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Thanks for selling my
inventory in your
store.
Consignee

Consignor
 6 - 41

GO O D S DA M A G E D OR OB S O L E T E

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.
Cost should be reduced to net realizable
value if they can 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.
 6 - 42

DE T E R M IN IN G IN V E N T O R Y CO S T S
Include all expenditures necessary to bring an item to
a salable condition and location.

Minus
Discounts Invoice Plus
Insurance
and
Allowances
Cost

Plus Import Plus

Duties Plus Storage
Freight
 6 - 43

WH IC H UN IT DID WE SE L L ?
When identical units of inventory have different unit costs, a
question naturally arises as to which of these costs should be
used in recording a sale of inventory.
 6 - 44

IN V E N T O R Y SU B S ID IA R Y LE D G E R
A separate subsidiary account is maintained for each
item in inventory.

How can we determine the unit cost for the Sept. 10 sale?
 6 - 45

COSTING METHODS
" Specific identification

" Cost flow assumptions

!First-in, first-out (FIFO)
!Last-in, first-out (LIFO) (not allowed in HK)
!Weighted-average cost
 6 - 46

SPECIFIC IDENTIFICATION
" Each time a sale occurs, the actual invoice cost
of the units sold is identified and charged to cost
of goods sold. This method requires to identify
which items were sold and when.

" If
each unit is unique, specific identification
method should be chosen.
 6 - 47

CO S T FL O W AS S U M P T IO N S
" Ifthe items in inventory are homogenous in
nature, companies normally adopt a more
convenient practice of using a cost flow
assumption to determine cost of goods sold and
the ending inventory account balance.

" The actual physical flow of inventory need not

correspond to these assumptions.
 6 - 48

IN V E N T O R Y CO S T FL O W
AS S U M P T IO N S
First-In, First-Out The Earliest costs to COGS,
(FIFO) leaving costs of most recent
purchases in inventory.
Last-In, First-Out Most recent costs to COGS,
(LIFO) leaving costs of earliest purchases
in inventory.

Weighted Each time a sale occurs, the weighted

Average average cost per unit is determined
the average cost of each unit in
inventory is assigned to COGS and
ending inventory.
 6 - 49

IN V E N T O R Y CO S T IN G IL L U S T R AT IO N
Here is information about the mountain bike inventory of Trekking
for the month of August.
Date Activity Units Acquired at Cost Units Sold at Retail Unit Inv.

Aug. 1 Beg. Inventory 10units @ $ 91 = $ 910 10

Aug. 3 Purchased 15units @ $ 106 = $ 1,590 25

Aug. 14 Sales 20 units @ $130 5

Aug. 17 Purchased 20units @ $ 115 = $ 2,300 25

Aug. 28 Purchased 10units @ $ 119 = $ 1,190 35

Aug. 31 Sales 23 units @ $150 12

Totals 55 $5,990 43
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SP E C IF IC ID E N T IF IC AT IO N
When units are sold, the specific cost of the units sold is
added to cost of goods sold.
Trekking sold 20 bikes on August 14th with the following costs:
8 bikes @ $ 91 = $ 728
12 bikes @ 106 = 1,272
Cost of goods sold = $ 2,000
The 23 bikes sold on August 31st had the following costs:
2 bikes @ $ 91 = $ 182
3 bikes @ 106 = 318
15 bikes @ 115 = 1,725
3 bikes @ 119 = 357
Cost of goods sold = $ 2,582
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SPECIFIC IDENTIFICATION

Income Statement
Cost of Goods Sold
Balance Sheet
Inventory
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FIR S T -IN , FIR S T -OU T (FIFO)

Cost of Goods Sold for August 31 = $

On August 31st, there are 12 units in inventory at $

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FIR S T -IN , FIR S T -OU T (FIFO)

Cost of Goods Sold for August 31 = $2,600

On August 31st, there are 12 units in inventory at $1,420 (2 @ $115 + 10 @ $119).

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LA S T -IN , FIR S T -OU T (LIFO)

Cost of Goods Sold for August 31 = $

On August 31st, there are 12 units in inventory at $

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LA S T -IN , FIR S T -OU T (LIFO)

Cost of Goods Sold for August 31 = $2,685

On August 31st, there are 12 units in inventory at $1,260: (5 @ $91 +,7 @ $115).
 6 - 56

WE IG H T E D AV E R A G E

Cost of Goods Sold for August 31 = $

After the August 31 sale, there are 12 units in inventory at $
 6 - 57

WE IG H T E D AV E R A G E

Cost of Goods Sold for August 31 = $2,622

After the August 31 sale, there are 12 units in inventory at $1,368: (12 @ $114)
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FIN A N C IA L STAT E M E N T EF F E C T S
O F CO S T IN G ME T H O D S

Advantages of Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current of goods sold with
replacement cost. revenues.
 6 - 59

FIN A N C IA L STAT E M E N T EF F E C T S
O F CO S T IN G ME T H O D S
Because prices change, inventory methods nearly always
assign different cost amounts.
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FINANCIAL STATEMENT EFFECTS

OF COSTING METHODS
" When inventory costs are increasing (inflation)
!LIFO cost of goods sold is highest, gross profit is
lowest.
!FIFO cost of goods sold is lowest, gross profit is
highest.
" When inventory costs are decreasing
!FIFO cost of goods sold is highest.
!LIFO cost of goods sold is lowest.
 6 - 61

TH E TA X AD VA N TA G E OF LIFO

FIFO LIFO
Gross profit $460 $340
Operating expenses 260 260
Income before taxes $200 $ 80
Income tax expense (40%) $ 80 $ 32

The most attractive feature of LIFO is low

income tax payments when prices are
increasing. (LIFO is not allowed in HK)
 6 - 62

CO N S IS T E N C Y IN US IN G CO S T IN G
ME T H O D S

The consistency principle requires a

company to use the same accounting
methods period after period so that financial
statements are comparable across periods.

May change inventory methods, but must

disclose the effects of the change on net income
 6 - 63

LOWER OF COST AND NRV

" Inventories
are recorded at their cost. However, if
inventory declines in value below its original cost, a
major departure from the historical cost principle
occurs. Inventory must be reported at NRV when
NRV is lower than cost.

" The term net realizable value (NRV) refers to the net
amount that a company expects to realize from the
sale of inventory.
!Specifically, net realizable value is the estimated selling
price in the normal course of business less estimated
costs to complete and estimated costs to make a sale.
 6 - 64

LO W ER O F CO ST AND NRV
Inventory must be reported at NRV when
NRV is lower than cost.

Consistent with Can be applied two ways:

the conservatism (1) separately to each
individual item.
principle. to major categories of
( )
assets.
 6 - 65

LO W ER O F CO ST AND NRV
A motor sports retailer has the following
items in inventory:
 6 - 66

LO W ER O F CO ST AND NRV
Here is how to compute lower of cost and
NRV for individual inventory items.
 6 - 67

US GAAP vs. IFRS

Topic IFRS US GAAP
Method for determining LIFO is prohibited. LIFO is permitted
inventory cost
Use of cost formulas The same formula must The same formula does
be applied to all not need to be applied to
inventories that have a all inventories that have
similar nature and use to a similar nature and use
the entity to the entity

Measuring of carrying Lower of cost and net Lower of cost and market
amount realizable value (i.e. current replacement
cost)
Reversal of write-downs Required, if certain Prohibited
criteria are met
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4. Financial Statement Effects of Inventory

Errors
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IN V E N T O R Y ER R O R S : AN EX A M P L E
Period 1 Period 2 Period 3
Ending Inventory Beginning Inventory
Overstated Overstated
by 5,000 by 5,000 Correct
Sales Revenue 100,000 100,000 100,000
Cost of goods sold
Beginning inventory 10,000 15,000 10,000
Net purchases 50,000 50,000 50,000
Cost of goods available for
sale 60,000 65,000 60,000
Ending inventory (15,000) (10,000) (10,000)
Cost of goods sold 45,000 55,000 50,000
Gross profit 55,000 45,000 50,000

Note: The correct gross profit is 50,000 for each period

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AP P E N D IX 6B:
IN V E N T O R Y ES T IM AT IO N ME T H O D S
Inventory sometimes requires estimation for interim statements or
if some casualty such as fire or flood makes taking a physical
count impossible.

Retail Inventory Method Gross Profit Method