Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-1
CHAPTER 7
REPORTING AND INTERPRETING
COST OF GOODS SOLD AND INVENTORY
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
1. Apply the cost principle to identify the
amounts that should be included in
inventory and the expense matching
principle to determine cost of goods
sold for typical retailers, wholesalers,
and manufacturers.
1, 2, 3, 4
1, 2, 3, 4
1
1, 4
2. Report inventory and cost of goods
sold using the four inventory costing
methods.
5
5, 6, 7, 8,
9, 10
2, 3, 4, 5
1, 2, 3
1, 2, 8
3. Decide when the use of different
inventory costing methods is
beneficial to a company.
6
7, 8, 9,
10
3, 4, 5
2, 3
8
4. Report inventory at the lower of cost
or market (LCM).
7
11, 12
6
2
5. Evaluate inventory management using
the inventory turnover ratio.
8
13, 14,
15
7
1, 2, 3, 5,
8
6. Compare companies that use different
inventory costing methods.
14, 15
8
5, 6
7. Understand methods for controlling
inventory, analyze the effects of
inventory errors on financial
statements, and analyze the effect of
inventory on cash flows.
9
16, 17,
18, 19
7, 9
4
2, 8
Chapter Supplement A: LIFO liquidations
20
10
Chapter Supplement B: FIFO and LIFO
cost of goods sold under periodic and
perpetual inventory systems
21
Chapter Supplement C: Additional issues
in measuring purchases
22
Synopsis of Chapter Revisions
Focus Company: Harley-Davidson, Inc.
▪ Focus and contrast company data updated.
▪ Coverage of perpetual versus periodic inventory systems moved to section on cost of goods sold, near the
beginning of the chapter.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on computation of
goods available for sale and cost of goods sold.
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
Synopsis of Chapter Revisions, continued
▪ Exhibits 7.4 and 7.5 revised to make it easier to see the effects of FIFO, LIFO, and average costing
methods on the financial statements.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on computing cost of
goods sold and ending inventory under FIFO and LIFO costing methods.
▪ New Appendix B added demonstrating the effects of determining FIFO and LIFO cost of goods sold
under periodic versus perpetual inventory systems.
▪ New CONTINUING CASE added to the end-of-chapter problems. Students are asked to determine the
financial statement effects of the choice between FIFO and LIFO when inventory costs are increasing and
when they are decreasing for Pool Corporation.
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases.
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Apply the cost principle to identify the amounts that should be included in
inventory and the expense matching principle to determine cost of goods
sold for typical retailers, wholesalers, and manufacturers.
7-1 through 7-4
2. Report inventory and cost of goods sold using the four inventory costing
methods.
7-5 through 7-19
3. Decide when the use of different inventory costing methods is beneficial to
a company.
7-20 through 7-24
4. Report inventory at the lower of cost or market (LCM).
7-25 through 7-26
5. Evaluate inventory management using the inventory turnover ratio.
7-27 through 7-31
6. Compare companies that use different inventory costing methods.
7. Understand methods for controlling inventory, analyze the effects of
inventory errors on financial statements, and analyze the effect of inventory
on cash flows.
7-32 through 7-34
Chapter Supplement A: LIFO liquidations
7-35
Chapter Supplement B: FIFO and LIFO cost of goods sold under periodic and
perpetual inventory systems
7-36
Chapter Supplement C: Additional issues in measuring purchases
7-37 through 7-38
Related Video Program
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-3
Chapter Take-Aways
1. Apply the cost principle to identify the amounts that should be included in inventory and the
expense matching principle to determine cost of goods sold for typical retailers, wholesalers,
and manufacturers.
Inventory should include all items owned that are held for resale. Costs flow into inventory when
goods are purchased or manufactured. They flow out (as an expense) when they are sold or disposed
of. In conformity with the expense matching principle, the total cost of the goods sold during the
period must be matched with the sales revenue earned during the period. A company can keep track
of the ending inventory and cost of goods sold for the period using (1) the perpetual inventory system,
which is based on the maintenance of detailed and continuous inventory records, and (2) the periodic
inventory system, which is based on a physical count of ending inventory and use of the cost of goods
sold equation to determine cost of goods sold.
2. Report inventory and cost of goods sold using the four inventory costing methods.
The chapter discussed four different inventory costing methods used to allocate costs between the
units remaining in inventory and to the units sold, and their applications in different economic
circumstances. The methods discussed were FIFO, LIFO, average cost, and specific identification.
Each of the inventory costing methods conforms to GAAP. Public companies using LIFO must
provide note disclosures that allow conversion of inventory and cost of goods sold to FIFO amounts.
Remember that the cost flow assumption need not match the physical flow of inventory.
3. Decide when the use of different inventory costing methods is beneficial to a company.
The selection of an inventory costing method is important because it will affect reported income,
income tax expense (and hence cash flow), and the inventory valuation reported on the balance sheet.
In a period of rising prices, FIFO normally results in a higher income and higher taxes, than LIFO; in
a period of falling prices, the opposite occurs. The choice of methods is normally made to minimize
taxes.
4. Report inventory at the lower-of-cost-or-market (LCM).
Ending inventory should be measured based on the lower of actual cost or replacement cost (LCM
basis). This practice can have a major effect on the statements of companies facing declining costs.
Damaged, obsolete, and out-of-season inventory should also be written down to their current
estimated net realizable value, if below cost. The LCM adjustment increases cost of goods sold,
decreases income, and decreases reported inventory in the year of the write-down.
5. Evaluate inventory management using the inventory turnover ratio.
The inventory turnover ratio measures the efficiency of inventory management. It reflects how many
times average inventory was produced and sold during the period. Analysts and creditors watch this
ratio because a sudden decline may mean that a company is facing an unexpected drop in demand for
its products or is becoming sloppy in its production management.
6. Compare companies using different inventory methods.
These comparisons can be made by converting the LIFO company’s statements to FIFO. Public
companies using LIFO must disclose the differences between LIFO and FIFO values for beginning
and ending inventory. These amounts are often called the LIFO reserve. The beginning LIFO reserve
minus the ending LIFO reserve equals the difference in cost of goods sold under FIFO. Pretax income
is affected by the same amount in the opposite direction. This amount times the tax rate is the tax
effect.
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-4
Chapter Take-Aways, continued
7. Understand methods for controlling inventory, analyze the effects of inventory errors on
financial statements, and analyze the effect of inventory on cash flows.
Various control procedures can limit inventory theft or mismanagement. A company can keep track
of the ending inventory and cost of goods sold for the period using (1) the perpetual inventory system,
which is based on the maintenance of detailed and continuous inventory records, and (2) the periodic
inventory system, which is based on a physical count of ending inventory and use of the inventory
equation to determine cost of goods sold. An error in the measurement of ending inventory affects
cost of goods sold on the current period’s income statement and ending inventory on the balance
sheet. Because this year’s ending inventory becomes next year’s beginning inventory, it also affects
cost of goods sold in the following period, by the same amount, but in the opposite direction. These
relationships can be seen through the cost of goods sold equation (BI + P − EI = CGS). When a net
decrease in inventory for the period occurs, sales are more than purchases; thus, the decrease must
be added in computing cash flows from operations. When a net increase in inventory for the period
occurs, sales are less than purchases; thus, the increase must be subtracted in computing cash flows
from operations.
Key Ratio
Inventory turnover ratio measures the efficiency of inventory management. It reflects how many times
average inventory was produced and sold during the period. It is computed as follows:
Inventory Turnover = Cost of Goods Sold Average Inventory
Finding Financial Information
BALANCE SHEET
Under Current Assets
Inventories
INCOME STATEMENT
Expenses
Cost of goods sold
STATEMENT OF CASH FLOWS
Under Operating Activities
(Indirect Method)
Net income
− increases in inventory
+ decreases in inventory
+ increases in accounts payable
− decreases in accounts payable
NOTES
Under Summary of Significant
Accounting Policies:
Description of management’s choice of inventory
accounting policy (FIFO, LIFO, LCM, etc)
In Separate Note
If not listed on balance sheet, components of inventory
(merchandise, raw materials, work in progress,
finished goods)
If using LIFO, LIFO reserve (excess of FIFO over
LIFO)
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-5
Chapter Outline
Teaching Notes
LO 1 – Apply the cost principle to identify the amounts that should be included in inventory and the
expense matching principle to determine cost of goods sold for typical retailers, wholesalers, and
manufacturers.
I. Nature of Inventory and Cost of Goods Sold
A. Items Included in Inventory
1. Inventory – tangible property that is (1) held for sale in
the normal course of business or (2) used to produce
goods or services for sale
2. Reported on balance sheet as a current asset; normally
used or converted into cash within one year or the next
operating cycle
Illustrated in Exhibit 7.1
3. Types:
a. Merchandise inventory – goods (or merchandise) held
for resale in the normal course of business; usually
acquired in a finished condition and ready for sale
without further processing
b. Manufacturing businesses hold three types of
inventory:
i. Raw materials inventory – items acquired for
processing into finished goods; included in raw
materials inventory until used, at which point it
becomes part of work in process inventory
ii. Work in process inventory – goods in the process
of being manufactured but not yet complete;
becomes finished goods inventory when completed
iii. Finished goods inventory – manufactured goods
that are complete and ready for sale
B. Costs Included in Inventory Purchases
1. Goods in inventory are initially recorded at cost; includes
the sum of the costs incurred in bringing an article to
usable or salable condition and location
See Financial Analysis
feature “Applying the
Materiality Constraint in
Practice”
2. In general, the company should cease accumulating
purchase costs when the raw materials are ready for use
or when the merchandise inventory is ready for shipment
a. Any additional costs related to selling the inventory
are incurred after the inventory is ready for use
b. These costs should be included in selling, general, and
administrative expenses in the period incurred
C. Flow of Inventory Costs
1. Merchandisers (wholesalers and retailers)
Illustrated in Exhibit 7.2
a. When merchandise is purchased, the merchandise
inventory account is increased;
b. When sold, cost of goods sold is increased and
merchandise inventory is decreased
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-6
2. Manufacturing environment:
Illustrated in Exhibit 7.2
a. When raw materials (also called direct materials) are
purchased, they are added to the raw materials
inventory
b. When used, the cost of these materials is removed
from the raw materials inventory and added to the
work in process inventory
c. Two other components of manufacturing cost are also
added to the work in process inventory when they are
used:
i. Direct labor cost – earnings of employees who
work directly on the products being manufactured
ii. Factor overhead costs – manufacturing costs that
are not raw material or direct labor costs
d. When the inventory items are completed and ready for
sale, the related amounts in work in process inventory
are transferred to finished goods inventory
e. When the finished goods are sold, cost of goods sold
increases, and finished goods inventory decreases
3. Three stages to inventory cost flows for both
merchandisers and manufacturers:
a. First stage involves purchasing and/or production
activities
b. Second stage activities result in additions to inventory
accounts on the balance sheet
c. Third stage involves the sale of the inventory items;
the amounts become cost of goods sold expense on the
income statement
D. Cost of Goods Sold Equation
1. Cost of goods sold (CGS) expense is directly related to
sales revenue
a. Sales revenue during an accounting period is the
number of units sold multiplied by the sales price
b. Cost of goods sold is the same number of units
multiplied by their unit costs
2. Cost of goods sold equation:
Illustrated in Exhibit 7.3
Beginning inventory
+ Purchases of merchandise
Goods available for sale
− Ending inventory
Cost of goods sold
3. Illustrated in Merchandise Inventory T-account:
Merchandise Inventory (A)
Beginning inventory
Add: Purchases of inventory
Deduct: Cost of goods sold
Ending inventory
Refer students to Pause for
Feedback – Self-Study Quiz
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-7
B. Perpetual and Periodic Inventory Systems
1. Perpetual Inventory System – A detailed inventory record
is maintained, recording each purchase and sale during
the accounting period
Assumed in journal entries
for purchases and sales in
text
a. The inventory record gives the amount of both ending
inventory and cost of goods sold at any point in time
b. A physical count should be performed periodically to
ensure records are accurate in case of errors or theft
2. Periodic Inventory System – Ending inventory and cost of
goods sold are determined at the end of the accounting
period based on a physical count
a. No up-to-date record of inventory is maintained
b. Actual physical count of the goods remaining on hand
is required at the end of each period
c. The number of units of each type of merchandise on
hand is multiplied by their unit cost to compute the
dollar amount of the ending inventory
d. Cost of goods sold is calculated using the cost of
goods sold equation.
i. Inventory purchases are debited to Purchases
account
ii. Cost of goods sold is not recorded until after the
inventory count is completed
e. Primary disadvantage is the lack of inventory
information
3. Perpetual Inventory Records and Cost Flow Assumptions
in Practice
a. Systems that do keep track of the costs of individual
items or lots normally do so on a FIFO or estimated
average (or standard) cost basis
b. Perpetual records are rarely kept on a LIFO basis;
LIFO companies convert the outputs of their perpetual
inventory system to LIFO with an adjusting entry
LO 2 – Report inventory and cost of goods sold using the four inventory costing methods.
II. Inventory Costing Methods
Show Video Program #7
A. Four generally accepted inventory costing methods are
available for determining cost of goods sold
1. 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
2. Specific identification identifies individual items that
remain in inventory or are sold; the remaining three
methods assume inventory costs follow a certain flow
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-8
B. Specific Identification Method
1. Specific identification method – identifies the cost of the
specific item that was sold
2. The specific identification method is impractical when
large quantities of similar items are stocked; appropriate
when dealing with expensive unique items
Note: Methods are applied as
C. Cost Flow Assumptions – Note that the choice of an
inventory costing method is not based on the physical flow
of goods on and off the shelves
if all purchases take place
before any sales and cost of
goods sold are recorded.
1. First-In, First-Out Method (FIFO)
Illustrated in Exhibit 7.4
a. FIFO assumes that the first goods purchased (the first
in) are the first goods sold (the first out)
i. First, each purchase is treated as if it were
deposited in the bin from the top in sequence
Have your students visualize
these inventory costing
methods as flows of inventory
in and out of a bin
ii. Each good sold is then removed from the bottom in
sequence; the cost of these goods becomes the cost
of goods sold (CGS).
iii. The cost of the remaining units become ending
inventory
b. FIFO allocates the oldest unit costs to cost of goods
sold and the newest unit costs to ending inventory
2. Last-In, First-Out Method (LIFO)
Illustrated in Exhibit 7.4
a. LIFO assumes that the most recently purchased units
(the last in) are sold first (the first out)
i. First, each purchase is treated as if it were
deposited in the bin from the top in sequence
ii. Each good sold is then removed from the bottom in
sequence; the cost of these goods become cost of
goods sold (CGS)
iii. The cost of the remaining units become ending
inventory
b. LIFO allocates the newest unit costs to cost of goods
sold and the oldest unit costs to ending inventory
3. Average Cost Method (Weighted Average Cost Method)
a. Average cost uses the weighted average unit cost of
the goods available for sale for both cost of goods sold
and ending inventory
b. Average Cost = Cost of Goods Available for Sale ÷
Number of Units Available for Sale
c. Cost of goods sold and ending inventory are assigned
the same weighted average cost per unit
Use Supplemental
Enrichment Activity #1
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-9
D. Perpetual Inventory Systems and Cost Flow Assumptions in
Practice
1. FIFO inventory and cost of goods sold are the same
whether computed on a perpetual or periodic basis
In reality, most companies
make numerous purchases
2. Accounting systems that keep track of the costs of
individual items normally do so on a FIFO or average
cost basis, regardless of the cost flow assumption used for
financial reporting
and sales of the same
inventory item throughout the
accounting period.
3. As a consequence, companies that wish to report under
LIFO convert the outputs of their perpetual inventory
system to LIFO with an adjusting entry at the end of each
period
4. By waiting until the end of the period to calculate this
LIFO adjustment, LIFO ending inventory and cost of
goods sold are calculated as if all purchases during the
period were recorded before cost of goods sold is
calculated and recorded.
See International Perspective
feature “LIFO and
International Comparisons”
LO 3 – Decide when the use of different inventory costing methods is beneficial to a company.
D. Financial Statement Effects of Inventory Methods
1. Each of the four alternative inventory costing methods is
in conformity with GAAP and the tax law
a. Methods differ only in the dollar amount of goods
available for sale allocated to cost of goods sold
versus ending inventory
Illustrated in Exhibit 7.5
b. Method that gives the highest ending inventory
amount gives the lowest cost of goods sold and the
highest gross profit, income tax expense, and income
amounts, and vice versa.
c. The average cost method generally gives income and
inventory amounts that are between the FIFO and
LIFO extremes
2. Impact of changing costs:
a. When unit costs are rising, LIFO produces lower
income and a lower inventory valuation than FIFO
b. When unit costs are declining, LIFO produces higher
income and higher inventory valuation than FIFO
E. Managers’ Choice of Inventory Methods
1. Factors considered when managers choose accounting
methods:
a. Net income effects (managers prefer to report higher
earnings for their companies)
b. Income tax effects (managers prefer to pay the least
amount of taxes allowed by law as late as possible—
the least–latest rule)
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-10
2. Any conflict between methods is normally resolved by
choosing one accounting method for external financial
statements and a different method for preparing its tax
return
3. LIFO conformity rule –LIFO is used on the income tax
return, it must also be used to calculate inventory and cost
of goods sold for the financial statements
4. Common choices:
a. For inventory with increasing costs, LIFO is most
often used because it normally results in lower income
taxes
b. For inventory with decreasing costs, FIFO is most
often used because it normally results in lower income
taxes
5. Consistency in Use of Inventory Methods
a. Regardless of the physical flow of goods, a company
can use any of the inventory costing methods.
b. A company is not required to use the same inventory
costing method for all inventory items
c. No particular justification is needed for the selection
of one or more of the acceptable methods
d. Accounting rules require companies to apply their
accounting methods on a consistent basis over time
See Question of Ethics
feature “LIFO and Conflicts
i. A company is not permitted to use one method one
period and a different method the next period
between Managers’ and
Owners’ Interests”
ii. A change in method is allowed only if the change
will improve the measurement of financial results
and financial position
Refer students to Pause for
Feedback – Self-Study Quiz
LO 4 – Report inventory at the lower of cost or market (LCM).
III. Valuation at Lower of Cost or Market
A. Cost Principle – inventories should be measured initially at
their purchase cost
B. Conservatism Constraint – departure from cost principle to
avoid overstating assets and income
C. Under LCM:
1. Companies recognize a “holding” loss in the period in
which the replacement cost of an item drops
Use Supplemental
Enrichment Activity #2
2. The holding loss is the difference between the purchase
cost and the lower replacement cost
3. The holding loss is the difference between the purchase
cost and the lower replacement cost. It is added to the
cost of goods sold for the period
4. LCM changes only the timing of cost of goods sold
D. Journal entry to record A $50,000 write-down inventory:
dr Cost of Goods Sold (+E, –SE)
50,000
cr Inventory (–A)
50,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 50,000 = Cost of Goods Sold (E) – 50,000
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-11
LO 5 – Evaluate inventory management using the inventory turnover ratio.
IV. Evaluating Inventory Management
A. Measuring Efficiency in Inventory Management
1. Goal of inventory management is sufficient quantities of
high-quality inventory to serve customers’ needs while
minimizing the costs of carrying inventory
B. Inventory Turnover Ratio
1. Inventory Turnover = Cost of Goods Sold ÷ Average
Inventory
2. Ratio reflects how many times average inventory was
produced and sold during the period
3. A higher ratio indicates that inventory moves more
quickly through the production process to the ultimate
customer, reducing storage and obsolescence costs
C. Average Days to Sell Inventory
1. Average Days to Sell Inventory = 365 ÷ Inventory
Turnover
2. Indicates the average time it takes the company to
produce and deliver inventory to customers
LO 6 – Compare companies that use different inventory costing methods.
D. Inventory Methods and Financial Statement Analysis
1. U.S. public companies using LIFO must report beginning
and ending inventory on a FIFO basis in the notes if the
FIFO values are materially different
2. Converting the Income Statement to FIFO
Illustrated in Exhibit 7.7
a. LIFO reserve ( or Excess of FIFO over LIFO) – a
contra-asset for the excess of FIFO over LIFO
inventory
b. Beginning LIFO Reserve (Excess of FIFO over LIFO)
− Ending LIFO Reserve (Excess of FIFO over LIFO)
= Difference in Cost of Goods Sold under FIFO
c. Difference in pretax income under FIFO x Tax rate =
Difference in taxes under FIFO
d. Decrease in Cost of Goods Sold Expense (Income
increases) – Increase in Income Tax Expense (Income
decreases) = Increase in Net Income
See Financial Analysis
3. Converting Inventory on the Balance Sheet to FIFO
feature “LIFO and Inventory
a. Adjust the inventory amounts on the balance sheet to
FIFO by substituting the FIFO values in the note
Turnover Ratio”
b. Alternatively, add the LIFO reserve to the LIFO value
on the balance sheet
Refer students to Pause for
Feedback – Self-Study Quiz
Chapter 07 – Reporting and Interpreting Cost of Goods Sold and Inventory
7-12
LO 7 – Understand methods for controlling inventory, analyze the effects of inventory errors on
financial statements, and analyze the effects of inventory on cash flows.
V. Control of Inventory
A. Internal Control of Inventory
1. Separation of responsibilities for inventory accounting and
physical handling of inventory
2. Storage of inventory in a manner that protects it from theft
and damage
3. Limiting access to inventory to authorized employees
4. Maintaining perpetual inventory records
5. Comparing perpetual records to periodic physical counts
of inventory.
B. Errors in Measuring Ending Inventory
1. Measurement of ending inventory affects both the balance
sheet (assets) and the income statement (cost of goods
sold, gross profit, and net income)
2. Measurement of ending inventory affects not only the net
income for that period but also the net income for the next
accounting period
a. Overstatement of ending inventory in current year:
i. Cost of goods sold is understated
ii. Income before taxes is overstated
b. Resulting overstatement of beginning inventory in
next year:
a. Cost of goods sold is overstated
Refer students to Pause for
Feedback – Self-Study Quiz
b. Income before taxes is understated
C. Inventory and Cash Flows
1. Since inventory is purchased on open credit, reconciling
cost of goods sold with cash paid to suppliers involves
changes in both Inventory and Accounts Payable
Illustrated in Exhibit 7.6
2. Inventory:
a. When a net decrease in inventory occurs, sales are
greater than purchases; thus, the decrease must be
added in computing cash flows from operations
b. When a net increase in inventory occurs, sales are less
than purchases; thus, the increase must be subtracted
in computing cash flows from operations
3. Accounts Payable:
a. When a net decrease in accounts payable occurs,
payments to suppliers are greater than new purchases;
thus, the decrease must be subtracted in computing
cash flows from operations
b. When a net increase in accounts payable occurs,
payments to suppliers are less than new purchases;
thus, the increase must be added in computing cash
flows from operations
Refer students to Pause for
Feedback – Self-Study Quiz