Inventories and Cost of Sales

Conceptual Chapter Objectives

C1: Identify the items making up
merchandise inventory.
C2: Identify the costs of merchandise
inventory.

5-2

Analytical Chapter Objectives

A1: Analyze the effects of inventory methods
for both financial and tax reporting.
A2: Analyze the effects of inventory errors on
current and future financial statements.
A3: Assess inventory management using both
inventory turnover and days sales in
inventory.

5-3

C1

Determining Inventory Items

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 in
Transit

Goods on
Consignment

Goods
Damaged or
Obsolete
5-4

C1

Goods in Transit
FOB Shipping Point
Public
Carrier
Seller

Buyer
Ownership passes
to the buyer here.
Public
Carrier

Seller

FOB Destination Point

Buyer
5-5

C2

Determining Inventory Costs

Include all expenditures necessary to bring an
item to a salable condition and location.
Minus
Discounts
and
Allowances
Plus Import
Tariffs

Invoice
Cost

Plus
Insurance

Plus
Freight

Plus
Storage
5-6

C2

Internal Controls and Taking a Physical

Count

Most
Most companies
companies take
take
aa physical
physical count
count of
of
inventory
inventory at
at least
least once
once
each
each year.
year.
When
When the
the physical
physical
count
count does
does not
not match
match
the
the Merchandise
Merchandise
Inventory
Inventory account,
account, an
an
adjustment
adjustment must
must be
be
made.
made.

Inv
e
Cou ntory
n
Qua t Tag
nt

Cou ity
nte
d_
Cou
__
n
t
e
by
___ d
___
_

5-7

P1

Inventory Costing Under a Perpetual

System

Accounting for
inventory
requires several
decisions . . .

Costing
Costing Method
Method

Specific
Specific Identification,
Identification, FIFO,
FIFO, LIFO,
LIFO,

or
or Weighted
Weighted Average
Average

Inventory
Inventory System
System

Perpetual
Perpetual or
or Periodic
Periodic

5-8

P1

Frequency in Use of Inventory

Methods

*The Other category includes

specific identification.
5-9

P1

Inventory Cost Flow Assumptions

First-In, First-Out
(FIFO)

Assumes costs flow in the

order incurred.

Last-In, First-Out
(LIFO)

Assumes costs flow in the

reverse order incurred.

Weighted
Average

Assumes costs flow at an

average of the costs
available.

5-10

P1

Inventory Costing Illustration

Example: Trekking Company inventory information

5-11

P1

Specific Identification

The
The above
above purchases
purchases were
were
made
made in
in August.
August. On
On August
August 14,
14,
the
the company
company sold
sold 88 bikes
bikes
originally
originally costing
costing $91
$91 and
and 12
12
bikes
bikes originally
originally costing
costing $106.
$106.
5-12

P1

Specific Identification

The
Thecost
costof
ofgoods
goodssold
soldfor
forthe
the20
20bikes
bikessold
soldon
onthe
theAugust
August
14
14sale
saleis
is$2,000.
$2,000.
88bikes
bikes@
@$$ 91
91
12
12bikes
bikes@
@$106
$106

== $$ 728
728
== $1,272
$1,272

After
Afterthis
thissale,
sale,there
thereare
arefive
fiveunits
unitsin
ininventory
inventorytotaling
totaling$500:
$500:
22bikes
bikes@
@$91
$91 ==
3 bikes @ $106 =

$$182
182
$ 318

5-13

P1

Specific Identification

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and28.
28.
The
Thecosts
costsof
ofthe
the23
23items
itemssold
soldon
onAugust
August31
31were
wereas
asfollows:
follows:
22@
@$91
$91
33@
@$106
$106
15
15@
@$115
$115
33@
@$119
$119

5-14

P1

Specific Identification

Cost
Cost of
of goods
goods sold
sold for
for
August
August 31
31 == $2,582
$2,582

5-15

P1

Specific Identification
Here are the entries to record the purchases and
sales. The numbers in red are determined by the cost
flow assumption used.

All purchases
and sales are
made on credit.
The selling price
of inventory was
as follows:
8/14
8/31

$130
$150

5-16

P1

First-In, First-Out (FIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.
5-17

P1

First-In, First-Out (FIFO)

The
The cost
cost of
of goods
goods sold
sold for
for the
the August
August
14
14 sale
sale is
is $1,970.
$1,970.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory totaling
totaling $530:
$530: 55 @
@ $106
$106
5-18

P1

First-In, First-Out (FIFO)

Cost
Cost of
of goods
goods sold
sold for
for the
the
August
August 31
31 sale
sale is
is == $2,600
$2,600
5-19

P1

First-In, First-Out (FIFO)

Income Statement
COGS = $4,570

Balance Sheet
Inventory = $1,420
5-20

P1

First-In, First-Out (FIFO)

Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost
flow assumption used.

All purchases
and sales are
made on credit.
The selling price
of inventory was
as follows:
8/14 $130
8/31 $150

5-21

P1

Last-In, First-Out (LIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.
5-22

P1

Last-In, First-Out (LIFO)

The
The cost
cost of
of goods
goods sold
sold for
for the
the August
August
14
14 sale
sale is
is $2,045.
$2,045.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory totaling
totaling $455:
$455:
55 @
@ $91
$91
5-23

P1

Last-In, First-Out (LIFO)

Cost
Cost of
of goods
goods sold
sold for
for the
the
August
August 31
31 sale
sale is
is == $2,685
$2,685
5-24

P1

Last-In, First-Out (LIFO)

Income
Statement COGS
= $4,730

Balance Sheet
Inventory = $1,260
5-25

P1

Last-In, First-Out (LIFO)

Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost
flow assumption used.

All purchases
and sales are
made on credit.
The selling price
of inventory was
as follows:
8/14 $130
8/31 $150

5-26

P1

Weighted Average
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

Total units in
inventory

5-27

P1

Weighted Average
Figuring Cost of Goods Sold

On August 14, 20 bikes are sold. To determine the cost of the

units sold, we first, need to compute the weighted average
cost per unit of items in inventory.

The
Thecost
costof
ofgoods
goodssold
soldfor
forthe
theAugust
August 14
14
sale
saleis
is$2,000.
$2,000. After
After this
thissale,
sale,there
thereare
are five
five
$100
$100units
unitsin
ininventory
inventorytotaling
totaling$500.
$500.
5-28

P1

Weighted Average

Additional
Additionalpurchases
purchaseswere
weremade
made on
onAugust
August17
17 and
and 28.
28.
Twenty-three
Twenty-threebikes
bikeswere
weresold
sold on
onAugust
August31.
31.
What is the weighted average cost per unit
of items in inventory?
5-29

P1

Weighted Average

Units
Units
Inventory
55
Inventory 8/14
8/14
Purchase
20
Purchase 8/17
8/17
20
Purchase
10
Purchase 8/28
8/28
10
Units
35
Units available
available for
for sale
sale
35

Cost of goods available for sale

Total units in inventory
Weighted average cost per unit

$
$

3,990
35
114

5-30

P1

Weighted Average

Cost
Cost of
of goods
goods sold
sold for
for
August
August 31
31 sale
sale is
is == $2,622
$2,622

Ending inventory is
composed of 12 units @
an average cost of $114
each or $1,368.
5-31

P1

Weighted Average

Income
Statement COGS
= $4,622
Balance Sheet
Inventory =
$1,368
5-32

P1

Weighted Average
Here are the entries to record the purchases and sales
entries for Trekking Co. The numbers in red are
determined by the cost flow assumption used.

All purchases and

sales are made on
credit.
The selling price
of inventory was
as follows:
8/14 $130
8/31 $150

5-33

A1

Financial Statement Effects of Costing

Methods
Because
Because prices
prices change,
change, inventory
inventory methods
methods nearly
nearly
always
always assign
assign different
different cost
cost amounts.
amounts.

5-34

A1

Financial Statement Effects of Costing

Methods

Advantages
Advantages of
of Methods
Methods
Weighted
Average

First-In,
First-Out

Last-In,
First-Out

Smoothes
Smoothes out
out
price
price changes.
changes.

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.
5-35

A1

Tax Effects of Costing Methods

The
The Internal
Internal Revenue
Revenue Service
Service (IRS)
(IRS)
identifies
identifies several
several acceptable
acceptable
methods
methods of
of inventory
inventory costing
costing for
for
reporting
reporting taxable
taxable income.
income.
If LIFO is used for tax
purposes, the IRS requires
it be used in financial
statements.
5-36

A1

Consistency in Using Costing

Methods
The
The consistency
consistency concept requires
requires aa
company
company to
to use
use the
the same
same
accounting
accounting methods
methods period after
period
period so
so that
that financial
financial statements
statements
are
are comparable across
across periods.
periods.

5-37

P2

Lower of Cost or Market

Inventory
Inventory must
must be
be reported
reported at
at market
market
value
value when
when **market
market is
is lower
lower than
than
cost.
cost.

*Market
*Market is
is defined
defined
as
as current
current
replacement
replacement cost
cost
(not
(not sales
sales price).
price).
Consistent
Consistent with
with
the
the conservatism
conservatism
constraint.
constraint.

LCM
LCM can
can be
be applied
applied three
three
ways:
ways:
(1)
separately
(1)
separately to
to each
each
individual
individual item.
item.
(2)
to
(2)
to major
major categories
categories of
of
items.
items.
(3)
to
(3)
to the
the whole
whole inventory.
inventory.

5-38

P2

Lower of Cost or Market

A
A motorsports
motorsports retailer
retailer has
has the
the following
following items
items
in
in inventory:
inventory:

5-39

P2

Lower of Cost or Market

Here
Here is
is how
how to
to compute
compute lower
lower of
of cost
cost or
or market
market
for
for individual
individual inventory
inventory items
items..

5-40

A2

Financial Statement Effects of Inventory

Errors
Income Statement Effects

My ending
inventory count
was understated!

Well, that messed

up my reported
income!

5-41

A2

Financial Statement Effects of Inventory

Errors
Balance Sheet Effects

5-42

A3

Inventory Turnover
Shows
Shows how
how many
many times
times aa company
company turns
turns over
over its
its
inventory
inventory during
during aa period.
period. Indicator
Indicator of
of how
how well
well
management
management is
is controlling
controlling the
the amount
amount of
of inventory
inventory
available.
available.
Inventory
turnover

Cost of goods sold

*Average inventory

5-43

A3

Days Sales in Inventory

Reveals
Reveals how
how much
much inventory
inventory is
is available
available in
in
terms
terms of
of the
the number
number of
of days
days sales.
sales.
Days' sales in
inventory

Ending inventory
Cost of goods sold

365

5-44

End of Chapter 5

5-45