1. Reporting and Interpreting Cost of Goods Sold and Inventory
Chapter 7
Chapter 7: Reporting and Interpreting Cost of Goods Sold and Inventory
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.

2. Inventory Costing Methods
Specific Identification
First-in, First-out
Last-in, First-out
Weighted Average
Total Dollar Amount of Goods Available for Sale
Ending Inventory
Cost of Goods Sold
Inventory Costing Method
Part I
When inventory costs have changed during an accounting period, which inventory costs are treated as sold or remaining in inventory can turn profits into losses and cause companies to pay or save millions in taxes. So the question to answer is: What amount is recorded as cost of goods sold when inventory is sold? The answer depends on which specific goods we assume are sold.
Four generally accepted inventory costing methods are available for doing so:
Specific Identification
First-in, First-out
Last-in, First-out
Weighted Average.
Part II
The four inventory costing methods are alternative ways to assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold.

3. Specific Identification
When units are sold, the specific cost of the unit sold is added to cost of goods sold.
First, let’s look at the specific identification method. In this method, we know the specific cost of each unit that is sold. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders.

4. FIFO LIFO Cost Flow Assumptions
The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves.
FIFO
The choice of an inventory costing method is not based on physical flow of goods on and off the shelves. That is why they are called cost flow assumptions. A useful tool for representing inventory cost flow assumptions is a bin, or container. Try visualizing these inventory costing methods as flows of inventory in and out of the bin. Following practice we will apply the methods as if all purchases during the period take place before any sales and costs of goods sold are recorded. Now, let’s look at an example of the first-in, first-out cost flow assumption method.
LIFO
Weighted Average

5. First-In, First-Out Method
Cost of Goods Sold
Oldest Costs
Ending Inventory
Recent Costs
When using first-in, first-out , we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory. In other words, the first-in, first-out method assumes that the first goods purchased (the first in) are the first goods sold.

6. First-In, First-Out
Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory.
Take a minute and review this chart for the mouse pad inventory for Computers, Incorporated. We will use this data throughout our inventory examples so we can compare our results at the end. There are 1,200 units in ending inventory and 1,050 units sold during the period.
First, let’s use the first-in, first-out method to determine the cost of the 1,200 units in ending inventory. Remember when we are using the first-in, first-out method, the costs of most recent purchases are in ending inventory. So, let’s start with November 29 purchase and add units purchased until we account for the 1,200 units in ending inventory.

7. First-In, First-Out
We start with the 200 units from the November 29 purchase, and we keep adding layers of purchases until we reach 1,200 units in ending inventory. The total cost of our ending inventory is $6,695.
Now we can start working on the cost of goods sold. Recall that we sold 1,050 units. Remember that when we use the first-in, first-out method the cost of the first items in (the oldest items) is allocated to cost of goods sold. Let’s look at the cost of good sold layers on the next slide.
Now, we have allocated the cost to all 1,200 units in ending inventory.

8. Now, we have allocated the cost to all 1,050 units sold.
First-In, First-Out
As you can see, we used the first units in from the beginning inventory and then added 50 units from the January 3 purchase to account for the 1,050 units sold. The cost of goods sold amounted to $5,515.
Now, we have allocated the cost to all 1,050 units sold.

9. First-In, First-Out
Here is the cost of ending inventory and cost of goods sold using FIFO.
Here is the completed inventory worksheet using the first-in, first-out method that shows the cost allocated to ending inventory and cost of goods sold.

10. Last-In, First-Out Method
Ending Inventory
Oldest Costs
Cost of Goods Sold
Recent Costs
When using last-in, first-out, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. In other words, the last-in, first-out method assumes that the last goods purchased (the last in) are the first goods sold.

11. Last-In, First-Out
Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.
Take a minute and review this chart for the mouse pad inventory for Computers, Incorporated. We used the same data earlier for the first-in, first-out example.
Now, let’s determine the cost of the 1,200 units in ending inventory using last-in, first-out. Remember when we are using the last-in, first-out method, the costs of the oldest purchases are in ending inventory. So, let’s start with beginning inventory and add units purchased until we account for the 1,200 units in ending inventory.

12. Last-In, First-Out
We start with the 1,000 units from the beginning inventory, and we keep adding layers of purchases until we reach 1,200 units in ending inventory. The total cost of our ending inventory is $6,310.
Now we can start working on the cost of goods sold. Recall that we sold 1,050 units. Remember that when we use the last-in, first-out method the cost of the last items in (the most recent items) is allocated to cost of goods sold. Let’s look at the cost of good sold layers on the next slide.
Now, we have allocated the cost to all 1,200 units in ending inventory.

13. Now, we have allocated the cost to all 1,050 units sold.
Last-In, First-Out
As you can see, we used the last units in from the November 29 purchase and then added units from other purchases to account for the 1,050 units sold. The cost of goods sold amounted to $5,900.
Now, we have allocated the cost to all 1,050 units sold.

14. Last-In, First-Out
Here is the cost of ending inventory and cost of goods sold using LIFO.
Here is the completed inventory worksheet using the last-in, first-out method to allocate costs to inventory and cost of goods sold.

15. Average Cost Method
When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.
Cost of Goods Available for Sale
Number of Units Available for Sale ÷
When using weighted average (also known as the average cost method), we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand. The average cost method uses the weighted average unit cost of the goods available for sale for both cost of goods sold and ending inventory.

16. Average Cost Method
First, we need to compute the weighted average cost of the items in inventory. We do this by dividing the cost of goods available for sale of $12,210 by the total units in inventory of 2,250. The average cost per unit is $
Next, we can compute the cost of ending inventory by multiplying 1,200 units times the average cost per unit of $ The cost of the ending inventory is $6,512.
We can also compute the cost of goods sold by multiplying 1,050 units times the average cost per unit of $ The cost of goods sold is $5,698.

17. Comparison of Methods
This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Because prices change, inventory methods nearly always assign different cost amounts. Everything is the same in each example, except the amount of Ending Inventory and Cost of Goods Sold and the flow through effects on Income Before Income Taxes, Income Tax Expense, and Net Income.
In periods of rising prices, of the three cost flow assumption methods, first-in, first-out will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. Last-in, first-out will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted Average will provide a Cost of Goods Sold amount that falls between first-in, first-out and last-in, first-out .
As you can see, the impact on net income is that first-in, first-out results in the highest net income, last-in, first-out results in the lowest net income and weighted average results in net income that falls in the middle of these two.

18. Financial Statement Effects of Costing Methods
Advantages of Methods
First-In, First-Out
Last-In, First-Out
Weighted Average
Ending inventory approximates current replacement cost.
Better matches current costs in cost of goods sold with revenues.
Smoothes out price changes.
An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. First-in, first-out does a great job of valuing Ending Inventory at an approximate replacement cost. This is because first-in, first-out uses the most recent costs to value Ending Inventory. Last-in, first-out does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because last-in, first-out uses the most recent costs to determine Cost of Goods Sold.

19. Managers Choice of Inventory Methods
Net Income Effects Managers prefer to report higher earnings for their companies.
Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible.
LIFO Conformity Rule
If last-in, first-out is used on the income tax return, it must also be used to calculate inventory and cost of goods sold for financial statements.
Part I
What motivates companies to choose different inventory costing methods? Most managers choose accounting methods based on two factors:
Net income effects (managers prefer to report higher earnings for their companies).
Income tax effects (managers prefer to pay the least amount of taxes allowed by law as late as possible.)
Any conflict between the two motives is normally resolved by choosing one accounting method for external financial statements and a different method for preparing its tax return.
Part II
The choice of inventory costing method must also consider the Last-in, first-out Conformity Rule. This rule states that if last-in, first-out is used on the income tax return, it must also be used to calculate inventory and cost of goods sold for financial statements.

20. LIFO and International Comparisons
LIFO Permitted?
IFRS also Prohibits the use of LIFO No
Yes
Singapore
China
The methods of accounting for inventories discussed in this chapter are used in most major industrialized countries. In several countries, however, the last-in, first-out method is not generally used. These differences can create comparability problems when one attempts to compare companies across international borders.
Canada
Australia
Great Britain

21. Go to Excel Assignment #2

22. Work AP7-1 (page 389)