1. Inventories Chapter 7 Chapter 7: Inventories.
© The McGraw-Hill Companies, Inc.

2. Reporting Inventory and Cost of Goods Sold
Merchandisers
Usually hold merchandise inventory, which they acquire in finished condition, ready for sale without further processing.
Manufacturers
Often hold three types of inventory, each of which represents a different stage in the manufacturing process.
AMERICAN EAGLE OUTFITTERS, INC.
Partial Consolidated Balance Sheet
At January 31, 2007
(in millions)
Assets
Current assets:
Cash and cash equivalents
$60
Short-term investments
767
Merchandise inventory
264
Accounts and note receivable 26
Prepaid expenses and other 34
AMERICAN EAGLE OUTFITTERS, INC.
Partial Consolidated Income Statement
For the Year Ended January 31, 2007
(in millions)
Assets
Net sales
$2,794
Cost of goods sold
1,454
Gross profit
1,340
Merchandisers usually hold merchandise inventory, which they acquire in finished condition, ready for sale without further processing. Manufacturers often hold three types of inventory, each of which represents a different stage in the manufacturing process. When goods are sold, their cost is removed from the inventory account and reported on the income statement as an expense called Cost of Goods Sold.

3. Cost of Goods Sold Equation
Beginning Inventory $40,000
Purchases $55,000
Cost of Goods
Available for Sale $95,000
Still here
Sold
A company starts each accounting period with a stock of inventory called beginning inventory (BI). During the accounting period, new purchases (P) are added to the beginning. The total of the beginning inventory and the total purchases for the period constitutes the total cost of goods available to be sold. Some of the goods available for sale will be sold during the period; some will not. The portion that is sold is reported as the cost of goods sold (CGS) on the income statement. The portion that remains unsold at the end of the period is reported as the ending inventory (EI).
Ending
Inventory $35,000
Cost of
Goods Sold $60,000
(Balance Sheet)
(Income Statement)
BI + P – CGS = EI

4. Cost of Goods Sold Equation
Cost of Goods Sold Calculation
Beginning inventory
$40,000
Plus: Purchases of merchandise during the year
55,000
Goods available for sale
95,000
Less: Cost of goods sold
60,000
Ending inventory
$35,000
+ Merchandise Inventory (A) -
BI ,000
P ,000
60, CGS
EI ,000
In our example, you can see that the company started the period with $40,000 in beginning inventory and added $55,000 of new purchases. The cost of goods available for sale amounted to $95,000. Of this total, $60,000 of inventory was sold and $35,000 remains in ending inventory. You can see the impact of the costs through the Merchandise Inventory account. Remember, Merchandise Inventory is an asset account and increases are shown on the left of debit side, and decreases are shown on the right or credit side.

5. Inventory Costing Methods
How do we determine cost of goods sold when the same inventory item is purchased at different prices?
5/3
Purchased 1 units of Product A for $70
5/5
Purchased 1 units of Product A for $75
5/6
Purchased 1 units of Product A for $95
5/8
Sold 2 units of Product A for $125 each.
Generally accepted inventory costing methods provide four methods of dealing with this problem:
Specific identification,
First-in, first-out (FIFO),
Last-in, first-out (LIFO), and
Weighted average
Generally accepted inventory costing methods provide four methods of dealing with this problem:
Specific identification,
First-in, first-out (FIFO),
Last-in, first-out (LIFO), and
Weighted average
Let’s see how these costing methods work when we purchase identical inventory items at varying costs. To keep our example simple, we are assuming three purchases of one units each at different costs. During the period we sold two of the units and one remains in ending inventory. Beginning inventory was zero.

6. Inventory Costing Methods
FIFO
LIFO
Weighted average
May 6 $95
May 6 $95
May 6 $95
$240 3
= $80
May 5 $75
May 5 $75
May 5 $75
1 × $80
2 × $80
May 3 $70
May 3 $70
May 3 $70
Income Statement
Net sales
$250
Cost of goods sold
145
Gross profit
$105
Balance Sheet
Inventory
$95
Income Statement
Net sales
$250
Cost of goods sold
170
Gross profit
$80
Balance Sheet
Inventory
$70
Income Statement
Net sales
$250
Cost of goods sold
160
Gross profit
$90
Balance Sheet
Inventory
$80
Part I
Here are the three items purchased and the date of purchase. Pay close attention to which costs are assigned to cost of goods sold and which costs reside in ending inventory. Let’s start with the first-in, first-out method. Under this costing method the oldest costs are assigned to cost of goods sold and the most recent costs are assigned to ending inventory.
Part II
Under the first-in, first-out (FIFO) costing method, the oldest purchases occurred on May 3rd and May 5th and are assigned to the two units sold. So, cost of goods sold with be one unit at $70 plus one unit at $75, for a total of $145. The ending inventory is assigned the costs of the most recent purchase of May 6th . So, the cost on ending inventory will be one unit at $95, for a total of $95. Now let’s look at the last-in, first-out (LIFO) method. Under this method, the most recent costs are assigned to cost of goods sold and the oldest costs are assigned to ending inventory.
Part III
As you can see the most recent costs come from the purchases of May 6th and May 5th and they are included in cost of goods sold. So, cost of goods sold is composed of one unit at $95 and one unit at $75, for a total of $170. Ending inventory is assigned the oldest costs which come from the purchase on Mary 3rd . So, ending inventory is composed of one unit at $70, for a total of $70. Notice the difference in cost of goods sold and ending inventory under FIFO and LIFO. Now, let’s turn our attention to the weighted average inventory costing method. Under this method, we calculate an average cost of the items including the beginning inventory plus the purchases and assign this average to cost of goods sold and ending inventory.
Part IV
We determine our average cost by adding together the cost of all items in beginning inventory and purchases. In our case the total cost of items purchased was $240, and we purchased a total of 3 items. The average cost of all the units available to be sold is $80 per unit ($240 divided by 3 units). There were two units sold, so the cost of goods sold will be assigned the cost of $160 (2 units times $80 average cost per unit). Ending inventory will be assigned a total cost of $80 (1 unit times $80 average cost per unit).

7. Cost-Flow Methods Under a Perpetual Inventory System
In a perpetual inventory system all inventory purchases, and sales and cost of goods sold are recorded in sequence as they occur. Consider the following information provided by American Eagle for it AE Alpine Bomber Jacket, each selling for $150 per unit.
Date
Description
Units
Unit Cost
Total Cost
Balance in Units
Jan. 1
Beginning inventory 20
$70
$1,400
Jan. 12
Purchase 60 80
4,800
Jan. 17
Sale 50 30
Jan. 19
100
2,000
Jan. 26 32 18
$8,200
Now, let’s look at a more complex application of the FIFO, LIFO and Average Cost methods of assigning costs to cost of goods sold and ending inventory. In a perpetual inventory system, all inventory purchases, and sales and cost of goods sold, are recorded in sequence as they occur. Consider the following information provided by American Eagle for it AE Alpine Bomber Jacket, that sell for $150 per unit.

8. First-In, First-Out Method FIFO
FIFO Perpetual Calculations
Purchases
Cost of Goods Sold
Inventory Balance
Units
Unit Cost
Total Cost
Jan. 1
Beginning inventory 20
$70
$1,400
Jan. 12
Purchase 60
$80
$4,800 80
4,800
Jan. 17
Sale 30
2,400
Jan. 19
100
2,000
Jan. 26 18
1,800 2
200
Totals
$6,800 82
$6,400
$1,800
Remember that in the FIFO costing method, the oldest items (the first ones into inventory) are the first ones sold (the first ones out of inventory). We use the costs of the oldest goods as of the date of sale to calculate the cost of goods sold. The cost of newer goods become the costs of the ending inventory.
Look carefully at the first sale on January 17th. On the date of sale the inventory consisted of 20 units from beginning inventory and 60 units from the purchase on January 12th. Under the FIFO method we assume we sell the beginning inventory first. So on January 17th, we assume we sell the 20 units from beginning inventory before we sell the units from our purchase. Since we sold 50 units, 20 of which came from beginning inventory, we need to get an additional 30 units, and these 30 units are assigned a cost of $80 each. Before the sale, we had 80 total units in inventory. We sold 50 of these units, so we have 30 units still in inventory. The 30 units in inventory are assigned a cost of $80 per unit for a total cost of $2,400.
Now, make sure you can complete the sale of January 26th and determine the cost of ending inventory. Notice that total cost of goods sold using FIFO is $6,400.

9. Last-In, First-Out Method (LIFO)
LIFO Perpetual Calculations
Purchases
Cost of Goods Sold
Inventory Balance
Units
Unit Cost
Total Cost
Jan. 1
Beginning inventory 20
$70
$1,400
Jan. 12
Purchase 60
$80
$4,800 80
4,800
Jan. 17
Sale 50
$4,000 70
1,400 10
800
Jan. 19
100
2,000
Jan. 26 18
1,800 2
140
Totals
$6,800 82
$6,940
$1,260
Remember that in the LIFO costing method, the newest goods (the last ones into inventory) are the first ones sold (the first ones out of inventory). We use the costs of the most recent goods as of the date of sale to calculate the cost of goods sold. The cost of older goods become the costs of the ending inventory.
Look carefully at the first sale on January 17th. On the date of sale the inventory consisted of 20 units from beginning inventory and 60 units from the purchase on January 12th. Under the LIFO method we assume we sell the purchases of January 12th first because they are the newest goods in inventory. So on January 17th, we assume we sell the 50 units from purchase of January 12th. Since we sold 50 units, they all came from the January 12th purchase. After the sale, inventory is composed of beginning inventory of 20 units at $70 each plus the remainder of the January 12th purchase, or 10 units at $80 per unit.
Now, make sure you can complete the sale of January 26th and determine the cost of ending inventory. Notice that total cost of goods sold using LIFO is $6,940.

10. Weighted Average Cost Method
Weighted Average - Perpetual
Purchases
Cost of Goods Sold
Inventory Balance
Units
Unit Cost
Total Cost
Jan. 1
Beginning inventory 20
$70.00
$1,400
Jan. 12
Purchase 60
$80
$4,800
80.00
4,800
Jan. 17
Sale 50
$77.50
$3,875 30
77.50
2,325
Jan. 19
100
2,000
100.00
Jan. 26 32
86.50
2,768 18
1,557
Totals 80
$6,800 82
$6,643
$1,557
Under the weighted average cost method, we calculate the weighted average cost per unit just before each sale is made. For example, our first sale was made on January 17th.. Right before the sale, the weighted average cost is determined by adding together the units in beginning inventory (20) and the units purchased on the 12th (60) for a total of 80 units. We do the same thing for the dollar costs. The cost of beginning inventory is $1,400 and the cost of the January 12th purchase is $4,800, for a total of $6,200. We divide the total cost of $6,200 by the total units to get the average cost per unit of $ We assign this average cost to the units sold and to the items remaining in ending inventory.
Now make sure you can calculate the new average cost right before the January 26th sale. You see that the new average cost per unit is $ The 18 units remaining in ending inventory are assigned the new average cost of $86.50 each. As you might have guessed, it is relatively easy to have some rounding error when we use the weighted average cost method.
($1,400 + $4,800) ÷ ( ) = $77.50 per unit
($2,325 + $2,000) ÷ ( ) = $86.50 per unit

11. Financial Statement Effects of Inventory Costing Methods
FIFO
LIFO
WAC
Effect on the Income Statement
Sales
$12,300
Cost of goods sold
6,400
6,940
6,643
Gross Profit
5,900
5,360
5,657
Effect on the Balance Sheet
Inventory
$1,800
$1,260
$1,557
Effects of Increasing Costs on the Financial Statements
Part I
As you can see on your screen, the cost of goods sold and gross profit on the income statement will be different under each of the three methods. In addition, the balance sheet cost of Merchandise Inventory will be different depending which method is selected by management. Once a company selects its inventory costing method, it usually stays with that method for a long period of time.
Part II
It is important to be careful when selecting an inventory costing method. In our example, you may have noticed the during the month of January prices for our inventory item were increasing. In a period of rising prices, FIFO yields the lower cost of goods sold, compared to LIFO, which means the company will report higher gross profit. However, if the company reports higher profits, it may pay higher taxes. Also, in a period of rising prices FIFO tends to give a higher cost of inventory on the balance sheet. While LIFO reports lower income than FIFO in a period of rising prices, the company generally pays lower taxes.
FIFO
LIFO
Inventory on balance sheet
Higher
Lower
Cost of goods sold on income statement

12. Financial Statement Effects of Inventory Costing Methods
FIFO
LIFO
WAC
Debit
Credit
Jan. 12
Inventory (+A)
4,800
Accounts Payable (+L)
Jan. 17
Cash (+A)
7,500
Sales Revenue (+R, +OE)
Cost of Goods Sold (+E, -OE)
3,800
4,000
3,875
Inventory (-A)
Jan. 19
2,000
Jan. 26
2,600
2,940
2,768
Here are the journal entries that will be made during the month of January under the three inventory costing methods. Remember that each bomber jacket sold for $150. Notice that the most important entries for you to understand are the recording of cost of goods sold and the reduction in inventory. The remaining entries are the same under all three inventory costing methods.

13. Do It……
The accounting records of Shumway AG Implement show the following data:
Beginning Inventory 4000 $3
Purchases $4
Sales $12
Determine the Cost of Goods sold during the period using the
FIFO Method
LIFO Method
Average method

14. Identifying the Effects of Inventory Errors
Errors in inventory valuations can significantly affect both the balance sheet and the income statement. As the cost of goods sold equation indicates, there is a direct relationship between ending inventory and the cost of goods sold: items that are not in the ending inventory are assumed to have been sold. So, errors in ending inventory will affect both the balance sheet (current assets) and the income statement (cost of goods sold, gross profit, and net income).
Errors in inventory valuations can significantly affect both the balance sheet and the income statement. As the cost of goods sold equation indicates, there is a direct relationship between ending inventory and the cost of goods sold: items that are not in the ending inventory are assumed to have been sold. So, errors in ending inventory will affect both the balance sheet (current assets) and the income statement (cost of goods sold, gross profit, and net income).

15. Income Statement Effect
Let’s assume that ending inventory was overstated by $10,000 due to an error that was not discovered until the following year.
Current Year
Beginning inventory
Accurate +
Purchases of merchandise during the year
Goods available for sale −
Ending inventory (balance sheet)
Overstated $10,000 =
Cost of goods sold (income statement)
Understated $10,000
Next Year
Beginning inventory
Overstated $10,000 +
Purchases of merchandise during the year
Accurate
Goods available for sale −
Ending inventory (balance sheet) =
Cost of goods sold (income statement)
Part I
In our example, the ending inventory is overstated by $10,000. In the current year, cost of goods sold will be understated by $10,000, so gross profit will be overstated by $10,000.
Part II
If the error was not corrected in the next year, beginning inventory would be overstated by $10,000, because the ending inventory in one period becomes the beginning inventory in the next period. If beginning inventory is overstated then goods available for sale will also be overstated. If we overstate cost of goods available for sales in Year 2, we also overstate cost of goods sold by the same amount. If cost of goods sold is too high, gross profit will be too low by $10,000.

16. Income Statement Effect
Let’s assume that ending inventory was overstated by $10,000 due to an error that was not discovered until the following year.
Current Year
With the Error
Without the Error
Sales
$120,000
Beginning inventory
$50,000
Purchases
75,000
Cost of goods available for sale
125,000
Ending inventory
45,000
35,000
Cost of goods sold
80,000
90,000
Gross profit
40,000
30,000
Operating expenses
10,000
Net income
$30,000
$20,000
Overstated $10,000
Part I
Here is a more detailed look at the $10,000 overstatement of ending inventory. Notice that net income is also overstated by the same amount.
Part II
In the next year, net income will be understated by $10,000. In effect, the error is self-correcting over the two year period. However, the income statement and balance sheet are incorrect in each of the two years.
Next Year
With the Error
Without the Error
Sales
$110,000
Beginning inventory
$45,000
$35,000
Purchases
70,000
Cost of goods available for sale
115,000
105,000
Ending inventory
20,000
Cost of goods sold
95,000
85,000
Gross profit
15,000
25,000
Operating expenses
10,000
Net income
$5,000
$15,000
Understated $10,000

17. Balance Sheet Effects Year Endng Inventory Error Assets Owners' Equity
Current
Overstated $10,000
Next
Accurate
This is the impact of the error over the two year period. Remember, not all errors are self-correcting. It is better to discover the error early and make the necessary accounting corrections.

18. Supplement A: Periodic Inventory System
In a periodic inventory system the computations are made as if all purchases during the period take place before any sales or cost of goods sold are recorded. Consider the following information provided by American Eagle relating to its AE Alpine Bomber Jacket for the month of January.
Unit
Total
Date
Description
Units
Cost
Jan. 1
Beginning inventory 20
$70
$1,400
Jan. 12
Purchase 60 80
4,800
Jan. 19
100
2,000
Sales during the month
(82)
$8,200
In Supplement A to this chapter, we want to look at the calculation of cost of goods sold and ending inventory under various inventory costing methods, but assuming the company uses the periodic inventory system. We will use the same inventory information as in our previous example. Notice that we only need to know the total units sold during the period, and not the date of the sale. Remember, in a periodic inventory system, the computations are made as if all purchases during the period take place before any sales or cost of goods sold are recorded.
BI + P – EI = CGS

19. First-In, First-Out Method (FIFO)
Cost of Goods Sold and Ending Inventory Calculation (FIFO)
Beginning inventory
(20 units at $70 each)
$1,400
Add: Purchases
(60 units at $80 each)
4,800
(20 units at $100 each)
2,000
Goods available for sale
$8,200
Less: Ending Inventory
(18 units at $100 each)
1,800
Cost of goods sold
$6,400
Cost of Goods Sold
(20 × $70)
$1,400
(60 × $80)
4,800
(2 × $100)
200
$6,400
We know that we sold 82 units during the period and assume the company is using the FIFO inventory costing method. Under this method, the first goods in our inventory are the first goods sold. The cost of goods sold for the 82 units would be made up of 20 units from beginning inventory, 60 units from the purchase on January 12th, and the remaining 2 units from the purchase of January 19th. Ending inventory would contain units with the most recent cost, or 18 units from the purchase of January 19th.

20. Last-In, First-Out Method (LIFO)
Cost of Goods Sold and Ending Inventory Calculation (LIFO)
Beginning inventory
(20 units at $70 each)
$1,400
Add: Purchases
(60 units at $80 each)
4,800
(20 units at $100 each)
2,000
Goods available for sale
$8,200
Less: Ending Inventory
(18 units at $70 each)
1,260
Cost of goods sold
$6,940
Cost of Goods Sold
(2 × $70)
$140
(60 × $80)
4,800
(20 × $100)
2,000
$6,940
Remember that we sold 82 units during the period and assume the company is using the LIFO inventory costing method. Under this method, the last goods in our inventory are the first goods sold. The cost of goods sold for the 82 units would be made up of 20 units from the purchase of January 19th, 60 units from the purchase on January 12th, and the remaining 2 units from beginning inventory. Ending inventory would contain units with the oldest cost, or 18 units from the beginning inventory.

21. Average Cost Method (WAC)
Cost of Goods Sold and Ending Inventory Calculation (WAC)
Beginning inventory
(20 units at $70 each)
$1,400
Add: Purchases
(60 units at $80 each)
4,800
(20 units at $100 each)
2,000
Goods available for sale
$8,200
Less: Ending Inventory
(18 units at $82 each)
1,476
Cost of goods sold
(82 units at $82 each)
$6,724
$8,200 ÷ 100 units = $82 Average Cost
Under the average cost method we first calculate the average cost of the units available for sale during the period. As you can see, the cost of goods available for sale is $8,200, and we purchased a total of 100 units. The average cost per unit is $82. Ending inventory includes 18 units at an average cost of $82 each, and cost of goods sold is made up of 82 units at the same average cost per unit.

22. Financial Statement Effects of Inventory Costing Methods
FIFO
LIFO
WAC
Effect on the Income Statement
Sales
$12,300
Cost of goods sold
6,400
6,940
6,724
Gross Profit
5,900
5,360
5,576
Effect on the Balance Sheet
Inventory
$1,800
$1,260
$1,476
Effects of Increasing Costs on the Financial Statements
The generalizations we made about the impact of the various methods on Merchandise Inventory and Cost of Goods Sold during a period of rising prices remains the same under the perpetual and periodic methods.
FIFO
LIFO
Inventory on balance sheet
Higher
Lower
Cost of goods sold on income statement