CHAPTER 5
INVENTORIES AND COST OF SALES
Related Assignment Materials
Student Learning Objectives Questions
Quick
Studies* Exercises* Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Identify the items making up
merchandise inventory.
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C2. Identify the costs of
merchandise inventory.
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Analytical objectives:
A1. Analyze the effects of
inventory methods for both
financial and tax reporting.
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5-8 5-3, 5-4, 5-6
A2. Analyze the effects of
inventory errors on current and
future financial statements.
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A3. Assess inventory management
using both inventory turnover
and days’ sales in inventory.
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Procedural objectives:
P1. Compute inventory in a
perpetual system using the
methods of specific
identification, FIFO, LIFO,
and weighted average.
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5-6, 5-10,
5-11, 5-12,
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5-3, 5-7, 5-8 5-1, 5-2,
5-3, 5-4
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and gross profit methods to
estimate inventory. (Appendix
5B)
*See additional information on next page that pertains to these quick studies, exercises and problems.
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Additional Information on Related Assignment Material
The Serial Problem for Success Systems continues in this chapter. Problems 5-6A and 5-7A can be
completed using Excel.
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode
Synopsis of Chapter Revisions
Proof Eyewear: NEW opener with new entrepreneurial assignment
Streamlined inventory presentation by not repeating seller/buyer entries
Added several new T-accounts to help learning of inventory flow
New simplified presentation and exhibits for periodic inventory methods
New explanatory notes added to exhibits as learning aids
Updated inventory ratios section using Toys `R’ Us
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Chapter Outline Notes
I. Inventory Basics
A. Determining Inventory Items
Includes all goods that a company owns and holds for sale.
1. Goods in transit—included if ownership has passed.
2. Goods on consignment—owned by consignor.
3. Goods damaged or obsolete—not included if they cannot be
sold. If salable, included at a conservative estimate of their net
realizable value (sales price minus cost of making the sale).
B. Determining Inventory Costs
Includes cost of expenditures necessary, directly or indirectly, in
bringing an item to a salable condition and location.
1. Cost example: invoice price minus any discount, plus any
incidental costs such as import tariffs, transportation-in,
storage, insurance, etc.
2. Matching principle states that inventory costs should be
recorded against revenue in the period when inventory is sold.
3. Exception: Under the materiality principle or the cost-to-
benefit constraint (effort outweighs benefit), incidental costs
of acquiring inventory maybe deemed immaterial and
allocated to cost of goods sold in the period when they are
incurred.
C. Internal Controls and Taking a Physical Count
1. Events can cause the Inventory account balance to differ from
the actual inventory available.
2. Physical count is generally taken at the end of its fiscal year or
when inventory amounts are low (at least once per year).
3. Physical inventory is used to adjust the Inventory account
balance to the actual inventory on hand and thus account for
theft, loss, damage, and errors.
4. Internal controls (such as pre-numbered inventory tickets,
assigned primary and secondary counters, and manager
confirmations) are applied when a physical count is taken.
II. Inventory Costing Under a Perpetual System—Accounting for
inventory affects both the balance sheet and the income statement.
There are 4 commonly used inventory costing methods. Each assumes
a particular pattern of how cost flow through inventory. Physical flow
and cost flow need not be the same.
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Chapter Outline Notes
(Note: The following assumes a perpetual inventory system.
The periodic system is addressed in the appendix 5A outline.)
A. Inventory Cost Flow Assumptions
Four methods of assigning costs to inventory and cost of goods
sold are:
1. Specific identification—when each item in inventory can be
identified with a specific purchase and invoice, we can use this
method to assign actual cost of units sold to cost of goods sold
and leave actual cost of units on hand in the inventory
account.
2. First-in, first-out (FIFO)—when sales occur, the costs of the
earliest units acquired are charged to cost of goods sold,
leaving costs of most recent purchases in inventory.
3. Last-in, first-out (LIFO)—when sales occur, costs of the most
recent purchases are charged to cost of goods sold, leaving
costs of earliest purchases in inventory. (Note: LIFO comes
closest to matching current costs against revenues.)
4. Weighted average (also called average cost)—requires we
compute the weighted average cost per unit of inventory at the
time of each sale (cost of goods available divided by units
available). We charge this weighted average cost per unit
times units sold to cost of goods sold.
Note: Advanced computing technology has made perpetual
inventory systems more affordable and more widely used.
B. Financial Statement Effects of Costing Methods
When purchase prices are different, the 4 costing methods nearly
always assign different cost amounts. When costs regularly rise,
note the following results:
1. FIFO assigns the lowest amount to cost of goods sold yielding
the highest gross profit and the highest net income.
2. LIFO assigns the highest amount to cost of goods sold
yielding the lowest gross profit and the lowest net income.
3. Weighted average method yields results between FIFO and
LIFO.
4. Specific identification always yields results that depend on
which units are sold.
Note: When costs regularly decline the reverse of above occurs
for FIFO and LIFO.
All 4 methods are acceptable. Companies must disclose the
method used in its financial statements or notes. Each method
offers certain advantages:
1. FIFO assigns an amount to inventory on the balance sheet that
approximates current replacement costs.
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Chapter Outline Notes
2. LIFO better matches current costs with revenues on the
income statement.
3. Weighted average tends to smooth out erratic changes in costs.
4. Specific Identification exactly matches costs with revenues
they generate.
C. Tax Effects of Costing Methods
Since inventory costs affect net income, they have potential tax
effects. Companies can use different methods for financial
reporting and tax reporting. Exception: When LIFO is used for tax
purposes, IRS requires it also be used for financial statements.
D. Consistency in Using Costing Methods
The consistency principle requires that a company use the same
accounting methods period after period (for comparability) unless
a change will improve financial reporting. Full-disclosure
principle requires any change, its justification and effect of net
income be reported.
III. Valuing Inventory at LCM and the Effects of Inventory Errors
A. Lower of Cost or Market (LCM)
Accounting principles require that inventory be reported on the
balance sheet at market value when market is lower than cost.
1. Market in the term LCM is defined as replacement cost.
2. LCM is applied in one of three ways:
a. to each individual item separately
b. to major categories of products
c. to the entire inventory.
3. The most widely used approach to apply LCM is to each
individual item in the inventory and only this approach is
illustrated in this chapter.
4. When replacement cost (market) drops below cost, inventory
is adjusted downward to market value with the following
entry: Debit to cost of goods sold and credit Inventory for the
amount of the decrease.
5. LCM is often justified with reference to conservatism
principle.
B. Financial Statement Effects of Inventory Errors
1. Inventory errors cause misstatements in cost of goods sold,
gross profit, net income, current assets, and equity.
2. Erroneous ending inventory of one period becomes erroneous
beginning inventory of the next and results in misstatements in
that next period’s statements.
3. An inventory error, although serious, is said to be self-
correcting because it always yields an offsetting error in the
next period.
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Chapter Outline Notes
4. Understated ending inventories result in understated assets and
equity (on balance sheet), and an understated net income (on
income statement) that period. Note: overstated ending
inventories have the reverse effects.
5. Beginning inventory errors do not affect the balance sheet but
do affect the current period’s net income.
IV. Global View—Compares U.S. GAAP to IFRS
A. Items and costs making up inventory—both systems include broad
and similar guidance.
B. Assigning costs to inventory—both systems allow specific
identification. GAAP also allows FIFO, Weighted Average, and
LIFO. IFRS does not currently allow LIFO but does allow FIFO
and Weighted Average.
C. Estimating inventory costs—Both systems apply LCM to write
down decline in inventory value. Only IFRS allows reversals to
original cost if market increases in future periods
V. Decision Analysis—Inventory Turnover and Days’ Sales in
Inventory
A. Inventory Turnover
1. Calculated by dividing cost of goods sold by average
merchandise inventory.
2. Reveals how many times a company turns over (sells) it
inventory during a period.
3. Users apply it to analyze short-term liquidity and to assess
management’s ability to control inventory availability.
4. A low ratio (in comparison to competitors) suggests inefficient
use of assets and a high ratio suggests inventory may be too
low.
B. Days’ Sales in Inventory
1. Reveals how much inventory is available in terms of the
number of days’ sales (how many days one can sell from
inventory if no new items are purchased).
2. Calculated by dividing ending inventory by cost of goods sold,
and then multiplying the result by 365.
C. Analysis of inventory management
A major emphasis for most merchandisers to both plan and control
inventory purchases and sales.
VI. Inventory Costing Under a Periodic System (Appendix 5A)
A. The basic aim of the periodic and perpetual system is the same.
The aim is to assign costs to inventory and cost of goods sold.
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Chapter Outline
Notes
B. When you use Periodic Inventory System, you don’t keep track of
the units you sell during the period. To compute cost of goods
sold you first compute the cost of the units on hand and then
subtract the cost of ending inventory from cost of goods available
for sale to determine cost of goods sold.
Cost of goods available for Sale
less: Cost of ending inventory
Cost of Goods Sold
C. The same four methods of assigning costs are used in each system
but the results may differ by inventory system due to timing of
cost assignment (Note: perpetual—cost assigned at point of sale
vs. periodic—costs assigned at year end when physical count is
taken).
1. Specific identification—periodic results will be same as
perpetual since specific cost will always be the same
regardless of system used.
2. First-in, first-out (FIFO)—periodic results will be same results
as perpetual since first costs will always be the same
regardless of system used.
3. Last-in, first-out (LIFO)—periodic results differ from
perpetual results because timing of cost assignment changes
what is identified as the last cost. Perpetual LIFO identifies
last cost at point of sale, whereas periodic LIFO identifies last
cost at year end.
4. Weighted average—periodic results differ from perpetual
because timing of cost assignment changes what costs are
averaged. Periodic weighted average is computed once at year
end and is based on total cost of goods available for sale and
total units available for sale.
D.Financial Statement Effects
A periodic system has the same general affects on financial
statements as perpetual system.
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VII. Inventory Estimation Methods (Appendix 5B) Notes
A. Retail Inventory Method
Estimates the cost of ending inventory for interim statements in a
periodic inventory system when a physical count is taken only
annually or to estimate if casualty loss makes physical count
impossible.
Steps:
1. Subtract sales (general ledger amount) from goods available
measured at retail price (retail data in supplementary records)
to get ending inventory at retail.
2. Find cost ratio by dividing total of goods available at cost by
total of goods available at retail.
3. Apply cost ratio to ending inventory at retail to convert to
ending inventory at cost.
B. Gross Profit Method
Estimates the cost of ending inventory for insurance claims when
inventory is destroyed, lost or stolen.
Preliminary steps:
1. Determine the normal gross profit percentage from recent years.
2. Find the cost of goods percentage (100% less gross profit
percentage).
Steps to estimate inventory using gross profit method:
Beginning Inventory (from general ledger account)
+ Cost of Goods Purchased (from general ledger account)
Goods Available for Sale at Cost
– Estimated Cost of Goods Sold (Net Sales x COGS%)
Estimated Ending Inventory
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VISUAL #5-1
Schedule of Cost of Goods Available
Units Cost Total
Jan. 1 Beginning Inventory 60 @ $10 = $ 600
Jan. 7 Purchase 90 @ 11 = 990
Jan. 15 Purchase 100 @ 13 = 1,300
Jan 25 Purchase 50 @ 16 = 800
Goods available for sale 300 $3,690
Sold a total of 230 units for $20 per unit. Timing of sales is as follows:
Jan. 1- Sold 30 units (actual CPU* $10)
Jan. 9- Sold 70 units (actual CPU: 20 @ $10 and 50 @ $11)
Jan 17-Sold 100 units (actual CPU: 50 @ $13, 30 @ $11 and 20 @ $10)
Jan 28-Sold 30 units (actual CPU: 20 @ 16, 10 @ $13)
*CPU= Cost per unit
Cost Flow Assumptions or
Methods of Assigning Cost to Units as Sold (CGS)
(Using a Perpetual Inventory System)
(1) 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 leaves the
actual cost of units left in inventory.
(2) Weighted Average – Each time a sale occurs, the weighted average cost per
unit is determined (based on total cost of goods available at point of sale
divided by total number of units of goods available at point of sale). This
cost is charged to cost of goods sold, leaving a weighted average cost in
inventory.
(3) First-in, First-out (FIFO) – Each time a sale occurs, the costs of the earliest
units acquired are charged to cost of goods sold, leaving costs of most recent
purchases in inventory.
(4) Last-in, First-out (LIFO) – Each time a sale occurs, costs of the most
recent purchases are charged to cost of goods sold, leaving costs of earliest
purchases in inventory.
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