Chapter 6
Inventory and Cost of Goods Sold
INSTRUCTOR’S MANUAL
Learning Objectives
LO6-1 Trace the flow of inventory costs from manufacturing companies to
merchandising companies.
LO6-2 Understand how cost of goods sold is reported in a multiple-step income statement.
LO6-3 Determine the cost of goods sold and ending inventory using different
inventory cost methods.
LO6-4 Explain the financial statement effects and tax effects of inventory cost flow
assumptions.
LO6-5 Record inventory transactions using a perpetual inventory system.
LO6-6 Apply the lower-of-cost-or-market method for inventories.
Analysis
LO6-7 Analyze management of inventory using the inventory turnover ratio and gross
profit ratio.
Appendix
LO6-8 Record inventory transactions using a periodic inventory system.
LO6-9 Determine the financial statement effects of inventory errors.
Teaching Suggestions
The chapter is designed to first introduce students to the simpler concepts related to inventory.
Part A begins with a discussion of service companies compared to manufacturing and
merchandising companies. This helps students make the transition from companies that provide
services (discussed in the first five chapters) to companies that sell products (this chapter). At
this point, the multiple-step income statement is introduced. The idea is to give student a clear
context to understand where in the income statement the primary topic of this chapter (cost of
goods sold) is reported separate from other expenses.
Once students are familiar with the concepts of ending inventory and cost of goods sold,
inventory cost methods are introduced. A continuous example with FIFO, LIFO, and
weighted-average cost demonstrates how companies are allowed to assume which inventory
items are sold. Once these methods have been reinforced, students are guided through the
different financial statement effects that arise from these inventory accounting choices.
Now that students are familiar with the concepts of calculating the cost of ending inventory
and cost of goods sold, Part B shows students how to record inventory transactions using the
perpetual inventory system. Appendix A (discussed below) will demonstrate how to record
inventory transactions using the periodic inventory system. Very few companies actually use the
periodic inventory system in practice to maintain their own (internal) records of inventory
transactions. Additional inventory transaction related to freight, purchase discounts, and purchase
returns are discussed, including showing students how companies make a simple adjustment to
convert their own FIFO (internal) records to LIFO for external reporting.
Part C of the chapter covers the lower-of-cost-or-market method. The
lower-of-cost-or-market method provides an easy illustration to understand the conservative
nature of generally accepted accounting principles.
The section on inventory analysis compares different inventory practices of Best Buy versus
Radio Shack. The differences in the business strategies of these two companies is clearly
revealed in the inventory turnover ratio, average days in inventory, and gross profit ratio.
There are two appendixes. Appendix A provides a side-by-side comparison of the periodic
inventory system and perpetual inventory system (from Part B). A side-by-side comparison helps
students to see precisely how the two recording systems differ. In practice, very few companies
report inventory and cost of goods sold using the LIFO perpetual system. Instead, as discussed in
Part B of the chapter, nearly all companies that report using LIFO maintain their own records on
a FIFO basis and then adjust for the LIFO difference for preparing financial statements. The
inventory recording and reporting procedures discussed in Part B of the chapter reflect those
used in actual practice.
Appendix B details the balance sheet and income statement effects that result from an
inventory error. One advantage of studying inventory errors is that they reinforce the relation
between ending inventory and cost of goods sold. To the extent that ending inventory is
overstated (understated), cost of goods sold is understated (overstated) in the year of the error. In
the following year, the effect on cost of goods sold is the opposite. A discussion of inventory
errors also demonstrates how the effect of an inventory error (even if never revealed) is reversed
in the following year, and the two-year effect of the error has no effect. This occurs because the
ending balance of inventory this year is the beginning balance next year.
Assignment Charts
Assignment Charts
Questions Learning
Objective(s) Topic
Time
(Min.)
1 LO6-1 Discuss the nature of inventory 5
2 LO6-1 Distinguish between a service company and
manufacturing or merchandising company
5
3 LO6-1 Describe components of inventory 5
4 LO6-2 Define cost of goods available for sale 5
5 LO6-2 Explain the balance of cost of goods sold and
inventory
5
6 LO6-2 Identify the purpose of the multiple-step income
statement
5
7 LO6-3 Explain recording inventory using assumed units
sold
5
8 LO6-3 List the three primary inventory cost flow
assumptions
5
9 LO6-4 Explain financial statement effects of inventory cost
flow assumptions
5
10 LO6-4 Explain financial statement effects of inventory cost
flow assumptions
5
11 LO6-4 Discuss FIFO as a balance sheet focus and LIFO as
an income statement focus
5
12 LO6-4 Discuss the LIFO conformity rule 5
13 LO6-5 Explain the periodic versus perpetual inventory
systems
5
14 LO6-5 Explain how freight, purchase returns, and purchase
allowances affect the cost of inventory
5
15 LO6-6 Explain the lower-of-cost-or-market inventory
method
5
16 LO6-6 Explain the lower-of-cost-or-market inventory
method
5
17 LO6-6 Describe the adjustment to write down inventory to
market value
5
18 LO6-6 Explain the lower-of-cost-or-market inventory
method and conservatism
5
19 LO6-7 Describe the inventory turnover ratio 5
20 LO6-7 Discuss the gross profit ratio 5
21 LO6-8 Explain how to record sale of inventory under
periodic system
22 LO6-8 Explain the purposes of the period-end adjustment
under the periodic system
23 LO6-9 Explain the financial statement effects of inventory
errors
5
24 LO6-9 Explain the financial statement effects of inventory
errors
5
Brief
Exercises Learning
Objective(s) Topic
Time
(Min.)
BE6-1 LO6-1 Understand terms related to types of companies 5
BE6-2 LO6-1 Understand terms related to inventory 5
BE6-3 LO6-2 Calculate cost of goods sold 5
BE6-4 LO6-2 Calculate amounts related to the multiple-step
income statement
10
BE6-5 LO6-3 Calculate ending inventory and cost of goods sold
using FIFO
10
BE6-6 LO6-3 Calculate ending inventory and cost of goods sold
using LIFO
10
BE6-7 LO6-3 Calculate ending Inventory and cost of goods sold
using weighted-average cost
10
BE6-8 LO6-3 Calculate ending inventory and cost of goods sold
using specific identification
10
BE6-9 LO6-4 Identify financial statement effects of FIFO and
LIFO
5
BE6-10 LO6-5 Record inventory purchases and sales using a
perpetual system
5
BE6-11 LO6-5 Record freight charges for inventory using a
perpetual system
5
BE6-12 LO6-5 Record purchase returns of inventory using a
perpetual system
5
BE6-13 LO6-5 Record purchase discounts of inventory using a
perpetual system
5
BE6-14 LO6-6 Calculate ending inventory using lower-of cost-
or-market
5
BE6-15 LO6-6 Calculate ending inventory using lower-of cost-
or-market
10
BE6-16 LO6-7 Calculate inventory ratios 10
BE6-17 LO6-8 Record inventory purchases and sales using a
periodic system
5
BE6-18 LO6-8 Record freight charges for inventory using a
periodic system
5
BE6-19 LO6-8 Record purchase returns of inventory using a
periodic system
5
BE6-20 LO6-8 Record purchase returns of inventory using a
periodic system
5
BE6-21 LO6-9 Find income statement effects of overstatement in
ending inventory
5
BE6-22 LO6-9 Find balance sheet effects of overstatement in
ending inventory
5
Exercises Learning
Objective(s) Topic
Time
(Min.)
E6-1 LO6-2 Calculate cost of goods sold 10
E6-2 LO6-2 Prepare a multiple-step income statement 15
E6-3 LO6-2 Prepare a multiple-step income statement and
analyze profitability
15
E6-4 LO6-3 Calculate inventory amounts when costs are rising 25
E6-5 LO6-3 Calculate inventory amounts when costs are
declining
25
E6-6 LO6-5 Record inventory transactions using a perpetual
system
10
E6-7 LO6-5 Record inventory purchase and purchase return
using a perpetual system
10
E6-8 LO6-5 Record inventory purchase and purchase discount
using a perpetual system
10
E6-9 LO6-5 Record transactions using a perpetual system 10
E6-10 LO6-5 Record transactions using a perpetual system 10
E6-11 LO6-5 Record transactions using a perpetual system 10
E6-12 LO6-5 Record transactions using a perpetual system 15
E6-13 LO6-6 Calculate inventory using lower-of-cost-or-market 15
E6-14 LO6-6 Calculate inventory using lower-of-cost-or-market 20
E6-15 LO6-2, 6-7 Calculate cost of goods sold, the inventory turnover
ratio, and average days in inventory
15
E6-16 LO6-6,6-7 Calculate levels of profitability for a multiple-step
income statement and the gross profit ratio
15
E6-17 LO6-8 Record transactions using a periodic system 20
E6-18 LO6-8 Record transactions using a periodic system 20
E6-19 LO6-8 Record transactions using a periodic system 20
E6-20 LO6-9 Find financial statement effects of understatement in
ending inventory
10
Problems Learning
Objective(s) Topic
Time
(Min.)
P6-1A LO6-3 Calculate ending inventory and cost of goods sold
for four inventory methods using a periodic
inventory system
30
P6-2A LO6-3, 6-4, 6-5 Calculate ending inventory, cost of goods sold, sales
revenue, and gross profit for four inventory methods
using a periodic inventory system
40
P6-3A LO6-2, 6-5 Record transactions and prepare a partial income
statement using a perpetual inventory system
25
P6-4A LO6-6 Report inventory using lower-of-cost-or market 20
P6-5A LO6-3, 6-6 Calculate ending inventory and cost of goods sold
using FIFO and LIFO and adjust inventory using the
lower-of-cost-or-market rule
20
P6-6A LO6-2, 6-3,
6-4, 6-5, 6-6
Determine cost of goods sold, record transactions
using a perpetual system, prepare a partial income
statement, and adjust for the lower-of
-cost-or-market method
25
P6-7A LO6-2, 6-7 Prepare a multiple-step income statement and
calculate the inventory turnover ratio and gross
profit ratio
20
P6-8A LO6-7 Use the inventory turnover ratio and gross profit
ratio to analyze companies
15
P6-9A LO6-8 Record transactions and calculate ending inventory
and cost of goods sold using a periodic inventory
system
20
P6-10A LO6-7, 6-9 Correct inventory understatement and calculate
gross profit ratio
25
P6-1B LO6-3 Calculate ending inventory and cost of goods sold
for four inventory methods using a periodic
inventory system
30
P6-2B LO6-3, 6-4, 6-5 Calculate ending inventory, cost of goods sold, sales
revenue, and gross profit for four inventory methods
using a periodic inventory system
40
P6-3B LO6-2, 6-5 Record transactions and prepare a partial income
statement using a perpetual inventory system
25
P6-4B LO6-6 Report inventory using lower-of-cost-or market 25
P6-5B LO6-3, 6-6 Calculate ending inventory and cost of goods sold
using FIFO and LIFO and adjust inventory using the
lower-of-cost-or-market rule
20
P6-6B LO6-2, 6-3,
6-4, 6-5,6
Determine cost of goods sold, record transactions
using a perpetual system, prepare a partial income
statement, and adjust for the lower-of
-cost-or-market method
20
P6-7B LO6-2, 6-7 Prepare a multiple-step income statement and
calculate the inventory turnover ratio and gross
profit ratio
20
P6-8B LO6-7 Use the inventory turnover ratio and gross profit
ratio to analyze companies
15
P6-9B LO6-8 Record transactions and calculate ending inventory
and cost of goods sold using a periodic inventory
system
20
P6-10B LO6-3, 6-9 Correct inventory understatement and calculate
gross profit ratio
25
Additional
Perspectives Topic
Time
(Min.)
AP6-1 Continuing Problem: Great Adventures 40
AP6-2 Financial Analysis: American Eagle Outfitters, Inc. 25
AP6-3 Financial Analysis: The Buckle, Inc. 25
AP6-4 Comparative Analysis: American Eagle Outfitters, Inc. vs. The
Buckle, Inc.
20
AP6-5 Ethics 20
AP6-6 Internet Research 30
AP6-7 Written Communication 25
AP6-8 Earnings Management 30
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10
questions at the end of each chapter. Each question covers the same learning objective but with a
little different twist. The correct answer is highlighted in bold for each item.
LO6-1
1. Which of following best describes a merchandising company?
a. A company whose revenues exceed expenses.
b. A company that produces products from raw materials, labor, and overhead.
c. A company that provides services to its customers.
d. A company that purchases products that are primarily in finished form for resale to
customers.
LO6-2
2. At the beginning of the year, Johnson Supply has inventory of $5,200. During the year, the
company purchases an additional $20,000 of inventory. An inventory count at the end of the year
reveals remaining inventory of $3,000. What amount will Bennett report for cost of goods sold?
a. $8,200.
b. $17,800.
c. $20,000.
d. $22,200.
LO6-2
3. Which of the following levels of profitability in a multiple-step income statement represents
all revenues less all expenses?
a. Gross profit.
b. Operating income.
c. Income before income taxes.
d. Net income.
LO6-3
4. Katie Malls has the following inventory transactions for the year:
Date Transaction
Number
of units
Unit
cost
Total
cost
Jan. 1 Beginning inventory 20 $35 $ 700
Apr. 8 Purchase 50 40 2,000
$2,700
Jan. 1 –
Dec. 31
Total sales to customers 60
What amount would Madison report for cost of goods sold using LIFO under a periodic
inventory system?
a. $2,100.
b. $2,350.
c. $2,300.
d. $2,400.
LO6-4
5. Which inventory cost flow assumption generally results in the lowest reported amount for
inventory when inventory costs are rising?
a. Specific identification.
b. First-in, first-out (FIFO).
c. Last-in, first-out (LIFO).
d. Average cost.
LO6-5
6. Under a perpetual inventory system:
a. Cost of good sold is recorded with a period-end adjusting entry.
b. Purchase discounts are not recorded.
c. Inventory purchases are recorded only at the end of the period.
d. Cost of goods sold is recorded with each sale.
LO6-6
7. At the end of a reporting period, Gaston Corporation determines that its ending inventory has a
cost of $6,500 and a market value of $5,800. The adjustment to write down inventory to market
value would include:
a. A debit to inventory for $5,800.
b. A credit to inventory for $700.
c. A debit to cost of goods sold for $5,800.
d. A credit to cost of goods sold for $700.
LO6-7
8. For the year, Sealy Incorporated reports net sales of $50,000, cost of goods sold of $40,000,
and an average inventory balance of $5,000. What is Sealy’s gross profit ratio?
a. 20%.
b. 10%.
c. 25%.
d. 30%.
LO6-8
9. Using a periodic inventory system, the sale of inventory on account would be recorded as:
a. Debit Cost of Goods Sold; credit Inventory.
b. Debit Inventory; credit Sales Revenue.
c. Debit Sales Revenue; credit Accounts Receivable.
d. Debit Inventory; credit Accounts Receivable.
LO6-9
10. Suppose Windell Corporation understates its ending inventory amount. What effect will this
have on the reported amount of net income in the year of the error?
a. Overstate net income.
b. Understate net income.
c. Have no effect on net income.
d. Not possible to determine with information given.
Alternate Let’s Review
Problem #1
For the current year, a company has the following beginning inventory and purchase.
Date Transaction
Number
of units
Unit
cost
Total
cost
Jan. 1 Beginning inventory 200 $20 $ 4,000
Jun. 15 Purchase 300 25 7,500
Total 500 $11,500
Throughout the year, the company sold a total of 450 units for $40 each, which leaves 50 units in
ending inventory.
Required:
1. Calculate cost of goods sold and ending inventory using the FIFO method.
Cost of goods available for sale = Cost of
goods sold +Ending
inventory
Beginning
inventory
and
purchases
Number
of units
xUnit
cost
=Total
Cost
Jan. 1 200 $20 $4,000 Sold
first
450
units
$4,000
Jun. 15{250 $25 $6,250 $6,250
50 $25 $1,250 Not Sold $1,250
500 $11,500 =$10,250 +$1,250