1. Inventories
and Cost of Goods Sold

2. Inventory of Wholesalers and Retailers
Purchased in finished form
Resold without transformation
Classified as “Merchandise Inventory” on balance sheet
LO1

3. Gap, Inc. Consolidated Balance Sheets [Partial]
ASSETS (in millions)
January 31, February 2,
CURRENT ASSETS:
Cash and cash equivalents $ 1,715 $ 1,724
Short term investments
Restricted cash
Merchandise inventory , ,575
Other
TOTAL CURRENT ASSETS , ,086
More
than
1/3 of
current
assets

4. Inventory of Manufacturers
Costs Included in Inventory
Direct
materials
Direct
labor
Manufacturing
overhead

5. Inventory of Manufacturers
Balance Sheet
Classifications
Costs Included
in Inventory
Direct
materials
Raw
materials
Manufacture
products
Direct
labor
Work in
process
Manufacturing
overhead
Finished
goods

6. IBM Consolidated Balance Sheets [Partial]
ASSETS (in millions)
2008
Current assets:
Inventories:
Raw materials $ 3,356
Work in progress ,107
Finished goods ,022
Supplies
Total inventories $ 8,781

7. Condensed Income Statement for a Merchandiser
Net sales $100,000
Cost of goods sold ,000
Gross profit $ 40,000
Selling and administrative expenses ,300
Net income before tax $ 10,700
Income tax expense ,280
Net income $ 6,420
LO2

8. Contra-Sales Accounts
Sales Discounts
Sales
normal
credit
balance
normal
debit
balance
Sales Returns
Sales Allowances
normal
debit
balance
normal
debit
balance

9. 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

10. The Cost of Goods Sold Model
Beginning
inventory
Purchases of
merchandise + =
Goods Available
for Sale
Less: Ending inventory
Cost
of goods
sold =
LO3

11. The Cost of Goods Sold Model
Beginning inventory $ 15,000
+ Cost of goods purchased ,000
= Cost of goods available for sale 78,000
– Ending inventory (18,000)
= Cost of goods sold $ 60,000
An increase in ending
inventory means more
was bought than sold
“Pool” of goods
available to sell
during the period

12. Perpetual Inventory Systems
Inventory records are updated after each purchase or sale
Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems

13. Periodic Inventory Systems
Inventory records are updated periodically based on physical inventory counts
Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements

14. Cost of Goods Purchased
Cost of inventory purchased (invoice price):
Less:
Purchase returns and allowances
Purchase discounts
Plus:
Transportation-in

15. To record purchase of inventory on account
Recording Purchases
Purchases ,000
Accounts Payable ,000
To record purchase of inventory on account

16. Recording Purchase Returns
Accounts Payable
Purchase Returns and Allowances
To record inventory returned to supplier

17. Recording Purchase Discounts
Accounts Payable
Cash
Purchase Discounts
($ 500 × 1% = $5 discount)
To record payment within discount period to supplier who offers 1% purchase discount.

18. Title passes at destination
FOB Destination Point
Title passes at destination
No sale or purchase until inventory reaches its destination
Seller responsible for inventory while in transit

19. Title passes when shipped
FOB Shipping Point
Both sale and purchase recorded upon shipment
Buyer responsible for inventory while in transit
Title passes when shipped

20. Recording Shipping Costs
Transportation-In
Cash
To record shipping costs on inventory purchased

21. Analysis of Profitability
particular
interest
to current and
potential
investors
Gross
Profit %
LO4 14 14

22. Daisy’s Profitability Gross Profit Ratio = Gross Profit
Net sales $100,000
Cost of goods sold ,000
Gross profit $ 40,000
Gross profit ratio = %
Gross Profit Ratio = Gross Profit
Net Sales
(How many cents on every $ of sales are left over after covering the cost of the product) 15 15

23. Inventory Valuation and Income Measurement
Value
assigned to
inventory
on balance
sheet
Value
expensed
as cost of
goods sold
on income
statement
When Sold =
LO5

24. Inventory Costs Included
Any freight costs incurred by buyer
Cost of insurance for inventory in transit
Cost of storing inventory before selling
Excise and sales taxes

25. Inventory Costing Methods
Four costing methods available:
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
LO6

26. Detailed Costing Method Example
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date Units Unit Cost
1/ $ 11 4/ 9/
12/
Total purchases 1,000 units
Ending inventory, Dec. 31: 600 units
Calculate the Cost of Goods Sold and Ending Inventory under each cost flow method

27. Specific Identification Method
Step 1: Identify the specific units in
inventory at the end of the year and their costs.

28. Specific Identification Method Units × Cost = Total cost
Units in ending inventory:
Date purchased Units Cost Total Cost
1/ $11 $ 1,100
4/ ,600
9/ ,600
Ending inventory $ 7,300
Units × Cost = Total cost

29. Specific Identification Method
Step 2: Identify the units sold and calculate the cost of goods sold.

30. Specific Identification Method Units × Cost = Total cost
Date purchased Units Cost Total Cost
Beg. inventory $10 $5,000
1/ ,200
4/ ,200
12/ ,400
Cost of goods sold $9,800
Units × Cost = Total cost

31. Weighted Average Method
Step 1: Calculate the cost of goods
available for sale.

32. Weighted Average Method
Date purchased Units Cost Total cost
Beg. inventory $ $ 5,000
1/ ,300
4/ ,800
9/ ,600
12/ ,400
Cost of goods
available for sale 1, $17,100

33. 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.

34. Weighted Average Method
Cost of Goods Available for Sale
Units Available for Sale
$17,100
1,500
= $11.40/unit

35. 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. ×
Avg.
Cost
# of
Units

36. Weighted Average Method
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
Units on hand
Units sold
Weighted average cost $ $ 11.40 ×
Total cost of goods
available of $17,100 allocated: $6, $10,260

37. First-in, First-out (FIFO) Method
Step 1: Assign the cost of the beginning
inventory to cost of goods sold.

38. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $ $5,000
1/ $11
4/ $12
9/ $13
12/ $14

39. 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.

40. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $ $5,000
1/ $ ,300
4/ / 100 $ $3, ,200
9/ $ ,600
12/ $ ,400
TOTALS $7, $9,500

41. Last-in, First-out (LIFO) Method
Step 1: Assign the cost of the last units purchased to cost of goods sold.

42. Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10
1/ $11
4/ $12
9/ $13
12/ $ $1,400

43. Last-in, First-out (LIFO) Method
Step 2: Work backwards until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

44. Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $ $5,000
1/ /200 $ , $ 2,200
4/ $ ,800
9/ $ ,600
12/ $ ,400
TOTALS $6, $11,000

45. Comparison of Costing Methods
Cost of
Goods
Sold
Goods Available for Sale
Ending
Inventory
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
LO7

46. Comparison of Costing Methods
Weighted
Average FIFO LIFO
In periods of rising prices:
Highest cost of goods sold?
Lowest cost of goods sold?
Highest gross profit?
Lowest net income?
Lowest income taxes? X

47. LIFO Issues LIFO liquidation
Liquidation can result in high gross profit (and large tax bill)
LIFO conformity rule
If used for tax, LIFO must also be used for books
LIFO reserve
Difference between inventory value stated at FIFO and value stated at LIFO

48. International Inventory Valuation Methods
Acceptable methods of costing inventory in the United States may not be acceptable in other countries
LIFO is generally accepted in the United States
IASB (international standards) prohibit the use of LIFO by companies that follow international standards
It is uncertain whether LIFO will survive as an acceptable inventory valuation method

49. Reasons for Inventory Errors
Mathematical mistakes
Physical inventory counting errors
Cutoff problems – in-transit
Goods on consignment
LO8

50. Effect of Inventory Errors on the Income Statement, 2010
Reported Corrected Effect
Sales $1, $1,000
Beginning inventory $ $ 200
Add: Purchases
Goods available for sale $ $ 900
Less: Ending inventory $50 OS
Cost of goods sold $ $ US
Gross margin $ $ OS
Operating expenses
Net income $ $ OS
OS = overstatement
US = understatement

51. Effect of Inventory Errors on the Income Statement, 2011
Reported Corrected Effect
Sales $1, $1,500
Beginning inventory $ $ $50 OS
Add: Purchases , ,100
Goods available for sale $1, $1, OS
Less: Ending inventory
Cost of goods sold $1, $1, OS
Gross margin $ $ US
Operating expenses
Net income $ $ US
OS = overstatement
US = understatement

52. Counterbalancing Errors
Assume ending inventory is overstated (+) by
$50 in 2010:
2010
Beginning inventory xxx
Add: Purchases xxx
= Goods available for sale xxx
Less: Ending inventory
= Cost of goods sold –50

53. Counterbalancing Errors
2010 ending inventory becomes 2011 beginning
inventory:
Beginning inventory $xxx
Add: Purchases xxx
= Goods available for sale xxx
Less: Ending inventory
= Cost of goods sold –50

54. Counterbalancing Errors
The 2010 error reverses in 2011 (but 2010 inventory
both 2010 and 2011 profits are misstated by 50):
Beginning inventory $xxx $+50
Add: Purchases xxx xxx
= Goods available for sale xxx
Less: Ending inventory xxx
= Cost of goods sold –

55. Report loss in year market falls below cost…
Lower of Cost or Market
Before After
Price Price Change Change
Cost $ $ 85
Report loss in year market falls below cost…
LO9

56. normal gross profit % when sold
Lower of Cost or Market
Before After
Price Price Change Change
Selling price $ $ 80
Cost
Gross profit $ $ 20
…to maintain
normal gross profit % when sold
Gross profit % % %

57. 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
Groups of items

58. Lower of Cost or Market under International Standards
Both U.S. GAAP and international financial reporting standards (IFRS) require lower-of-cost-or-market
Differences between U.S. GAAP and IFRS
How market value is defined
Recording changes in market value in future periods

59. Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
The number of times per period inventory is turned over (ie. sold)
LO10

60. Number of Days’ Sales in Inventory
Number of Days in the Period
Inventory Turnover Ratio
The average number of days
inventory is on hand before its sold

61. 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 –
Indirect
Method
LO11

62. Inventory Costing Methods with the Use of a Perpetual Inventory System
Appendix
Accounting Tools:
Inventory Costing Methods with the Use of a Perpetual Inventory System

63. FIFO Costing with a Perpetual System
FIFO applied at time of sale
Same FIFO inventory total under periodic
and perpetual systems

64. LIFO Costing with a Perpetual System
LIFO applied at time of sale
Different LIFO inventory total under periodic and perpetual systems because of pricing gap

65. Moving Average with a Perpetual System
New weighted average cost is computed for each purchase
Different inventory total under weighted average (periodic) and moving average (perpetual)