Chapter 08 – Inventories and the Cost of Goods Sold
Financial and Managerial Accounting, 17e 8-1
8 INVENTORIES AND
THE COST OF GOODS SOLD
Chapter Summary
The chapter is a detailed introduction to the cost flow assumptions used to value
inventories and measure the cost of goods sold.
Application of specific identification, average cost, FIFO and LIFO is first examined
within the context of a perpetual inventory system. The impact of the flow assumption employed
on income taxes is discussed in detail. The need for a physical inventory to assess inventory
shrinkage is also reviewed as are the accounting procedures necessary to record inventory
shrinkage. A brief presentation of lower-of-cost-or-market write downs concludes the discussion
of perpetual systems.
Application of the flow assumptions within a periodic system is next explained. We also
demonstrate that restatement of ending inventory by the periodic method results in the maximum
tax advantage from the LIFO flow assumption.
The chapter covers a number of additional issues surrounding inventory accounting.
These include: the financial statement effects of inventory errors; the retail and gross profit
methods for estimating ending inventory; and, an analysis of the inventory turnover ratio.
Learning Objectives
1. In a perpetual inventory system, determine the cost of goods sold using (a) specific
identification, (b) average cost, (c) FIFO, and (d) LIFO. Discuss the advantages and
shortcomings of each method.
2. Explain the need for taking a physical inventory.
3. Record shrinkage losses and other year-end adjustments to inventory.
4. In a periodic inventory system, determine the ending inventory and the cost of goods sold
using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO.
5. Explain the effects on the income statement of errors in inventory valuation.
6. Estimate the cost of goods sold and ending inventory by the gross profit method and by the
retail method.
7. Compute inventory turnover and explain its uses.
Brief topical outline
A The flow of inventory costs
1 Which unit did we sell?
Chapter 08 – Inventories and the Cost of Goods Sold
2 Data for an illustration
3 Specific identification
4 Cost flow assumptions
5 Average-cost method
6 First-in, first-out method
7 Last-in, first-out method
8 Evaluation of the methods
a Specific identification
b Average cost
c First-in, first-out
d Last-in, first-out
9 Do inventory methods really affect performance?
10 The principle of consistency
11 Just-in-time (JIT) inventory system – see Case in Point (page 350)
B Taking a physical inventory
1 Recording shrinkage losses
2 LCM and other write-downs of inventory
a The lower-of-cost-or-market (LCM) rule
3 The year-end cutoff of transactions
a Matching revenue and the cost of goods sold
b Goods in transit – see Your Turn (page 353)
4 Periodic inventory systems
a Applying flow assumption in a periodic system
b Specific identification
c Average cost
d FIFO
e LIFO – see Case in Point (page 355)
f Receiving the maximum tax benefit from the LIFO method
g Pricing the year-end inventory by computer
5 International Financial Reporting Standards
6 Importance of an accurate valuation of inventory
a Effects of an error in valuing ending inventory
b Inventory errors affect two years
c Effects of errors in inventory valuation: a summary
7 Techniques for estimating the cost of goods sold and the ending inventory
8 The gross profit method
9 The retail method
10 Textbook inventory systems can be modified…and they often are
C Financial analysis and decision making
1 Inventory turnover – see Your Turn (page 360)
2 Receivables turnover
3 Length of the operating cycle
4 Accounting methods can affect financial ratios
– see Ethics, Fraud & Corporate Governance (page 361)
D Concluding remarks
Chapter 08 – Inventories and the Cost of Goods Sold
Financial and Managerial Accounting, 17e 8-3
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings on
Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises
Exercises
Problems
Critical
Thinking
Cases
1
A
1, 2, 3
1, 3
2, 3
2, 3
1
2
B
5, 7, 9, 10
5, 7
7, 9, 10
5, 6, 7
3
C – D
15
10
12, 13, 14
3
Comments and observations
Teaching objectives for Chapter 8
Our specific teaching objectives in this chapter are to:
1 Explain why it is necessary for a company with an inventory to either use specific
identification or adopt a “flow assumption.”
2 Illustrate the “flow of costs” into the cost of goods sold account using each
costing method (specific identification, average cost, FIFO, and LIFO).
3 Discuss the factors to be considered in the selection of an appropriate cost method.
4 Illustrate the recording of shrinkage losses and other year-end adjustments to
inventory (excepting that in objective 6, below).
5 Illustrate the valuation of ending inventory using periodic costing procedures.
6 Explain why companies using perpetual LIFO might adjust the valuation of
inventory at year-end to the amount indicated by periodic LIFO costing procedures.
7 Illustrate the gross profit and retail methods of estimating the cost of goods sold
and ending inventory.
8 Discuss the purpose of computing a company‘s inventory turnover rate.
General comments
As in the previous edition, we emphasize the perpetual inventory system primarily because this is
the method now in predominant use. Teaching with an emphasis on perpetual inventory systems
has a number of benefits in the classroom.
Of greatest importance, a perpetual system shifts the focal point of cost assignment from
ending inventory to the cost of goods sold. As a result, the names of the flow assumptions finally
Chapter 08 – Inventories and the Cost of Goods Sold
“mean what they say.” For example, “first-in, first-out” means that the first costs are used in the
cost assignment process; “last-in, first-out” means that the last costs are used. Under a periodic
system, the reverse is true. (Experienced instructors will remember trying to explain to students
that “first-in, first-out” actually means that the latest costs are assigned to inventory, whereas
“last-in, first-out” really means the first costs are assigned.)
Not only do students more quickly grasp the concepts underlying the flow assumptions
when we assume a perpetual inventory system, but they also quickly grasp the effects of using
different assumptions during a period of rising prices. This enables us to emphasize the effects
of different methods upon earnings, income tax considerations, and even the implications of
LIFO reserves.
We use Exercise 2 to illustrate the basic cost-flow assumptions and follow it with a
discussion of Exercise 11 to demonstrate the effects of using alternative methods. Exercise 12
presents a more challenging analysis of the same points. We also discuss in class such topics as
“just-in-time” systems, inventory shrinkage, and the factors management should consider in
determining the optimal size of a company‘s inventory. These discussions portray inventory as
physical goods moving in and out of the business, rather than merely as a dollar amount. We
find that these discussions contribute to students’ interest, and also to their understanding of the
importance of inventories to accountants, managers, and investors.
Supplemental Exercises
Group Exercise
One of the most spectacular financial frauds of the 1980’s involved computer peripherals
manufacturer Miniscribe, Inc. Research the fraud and report on how inventory accounting by Miniscribe
contributed to the production of grossly misleading financial statements. Hint: A good place to begin
your research will be the Index of the Wall Street Journal.
Internet Exercise
Visit WalMart’s website at http://www.walmart.com/ and access their most recent annual
report. Locate the summary of significant accounting policies and find the inventory method(s) used by
WalMart.
Chapter 08 – Inventories and the Cost of Goods Sold
Financial and Managerial Accounting, 17e 8-5
CHAPTER 8 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1 The primary purpose of an inventory flow assumption is to:
a Increase inventory turnover.
b Increase gross profit.
c Determine which unit costs are assigned to inventory and which are assigned to the
cost of goods sold.
d Minimize taxable income during periods of rising prices.
2 During a period of steadily rising prices, which of the following inventory valuation
methods is likely to result in the lowest cost of goods sold?
a LIFO.
b FIFO.
c The retail method.
d The gross profit method.
3 The primary reason for the popularity of the LIFO flow assumption is that this method:
a Is most appropriate when each item in inventory is unique.
b Tends to minimize taxable income.
c Causes inventory to be reported at or near its current replacement cost.
d Reduces the amount of money “tied up” in inventory.
4 In a periodic inventory system, the cost of goods sold is determined by:
a Multiplying net sales for the period by a cost ratio.
b Journal entries made at the time of each sales transaction.
c Physically counting the quantities of merchandise sold each day, and determining
the cost of these items at year-end.
d Subtracting the cost assigned to the ending inventory from the cost of goods
available for sale during the period.
5 Salerno Co. has an inventory turnover rate of 7 and an accounts receivable turnover rate
of 5. Assuming 365 days in a year, the period of time required for Salerno to convert its
inventory into cash through normal business operations is approximately:
a 21 days.
b 52 days.
c 4 months.
d 2.5 months.
Chapter 08 – Inventories and the Cost of Goods Sold
CHAPTER 8 NAME #
10-MINUTE QUIZ B SECTION
Ace Systems, Inc. uses a perpetual inventory system. The company’s beginning inventory of a
particular product and its purchases during the month of January were as follows:
Quantity Unit Cost Total Cost
Beginning inventory (Jan. 1) ………………………… 10 $27.50 $275
Purchase (Jan. 15) ……………………………………….. 15 $28.00 $420
Purchase (Jan. 23) ……………………………………….. 5 $29.00 $145
Total ……………………………………………………… 30 $840
On January 28, Ace Systems sells 18 units of this product. The other 12 units remain in
inventory at January 31.
1 Refer to above data. Assuming that Ace Systems uses the average cost flow assumption,
the cost of goods sold to be recorded at January 28 is:
a $504. c $499.
b $336. d Some other amount.
2 Refer to above data. Assuming that Ace Systems uses the LIFO flow assumption, the
cost of goods sold on January 28 is:
a $331. c $499.
b $509. d Some other amount.
3 Refer to above data. Assuming that Ace Systems uses the FIFO flow assumption, the
cost of goods sold on January 28 is:
a $509. c $499.
b $341. d Some other amount.
4 Refer to above data. Assuming that Ace Systems uses the LIFO flow assumption, the 12
units of this product in inventory at January 31 have a total cost of:
a $499. c $509.
b $331. d Some other amount.
5 Refer to above data. Assuming that Ace Systems uses the FIFO flow assumption, the 12
units of this product in inventory at January 31 have a total cost of:
a $341 c $499.
b $509. d Some other amount.
Chapter 08 – Inventories and the Cost of Goods Sold
Financial and Managerial Accounting, 17e 8-7
CHAPTER 8 NAME #
10-MINUTE QUIZ C SECTION
Canfield uses a perpetual inventory system. The company’s beginning inventory of a particular product and
its purchases during the month of January were as follows:
Quantity Unit Cost Total Cost
Beginning inventory (Jan. 1) ………………………………………….. 50 $6 $300
Purchase (Jan. 10) …………………………………………………………. 25 $7 $175
Purchase (Jan. 22) …………………………………………………………. 25 $8 $200
Total ………………………………………………………………….. 100 $675
On January 25, Canfield sells 55 units of this product. The other 45 units remain in inventory at January 31.
a Determine the cost of goods sold using each of the following flow assumptions:
(1) LIFO $_____________
(2) FIFO $_____________
(3) Average cost $_____________
b Determine the cost of the 45 units in inventory at January 31 using each of the following flow
assumptions:
(1) LIFO $_____________
(2) FIFO $_____________
(3) Average cost $_____________
Chapter 08 – Inventories and the Cost of Goods Sold
CHAPTER 8 NAME #
10-MINUTE QUIZ D SECTION
Sherman Electric uses a periodic inventory system. The beginning inventory of a particular product, and the
purchases during the current year, were as follows:
Jan. 1 Beginning inventory ………………………… 60 units @ $105 = $ 6,300
Mar. 8 Purchase …………………………………………. 30 units @ $115 = 3,450
Aug. 11 Purchase …………………………………………. 90 units @ $125 = 11,250
Oct. 23 Purchase ………………………………………… 20 units @ $135 = 2,700
Total available for sale …………………………………….. 200 units $23,700
At December 31, the ending inventory of this product consisted of 65 units.
Using periodic costing procedures, determine (1) cost of the year-end inventory and, (2) cost of goods sold
relating to this product under each of the following flow assumptions:
(1) (2)
Inventory Cost of
at Dec. 31 Goods Sold
a Average cost $_______________ $_______________
b First-in, first-out $_______________ $_______________
c Last-in, first–out $_______________ $_______________
Chapter 08 – Inventories and the Cost of Goods Sold
Financial and Managerial Accounting, 17e 8-9
SOLUTIONS TO CHAPTER 8 10-MINUTE QUIZZES
QUIZ A QUIZ B
1 C 1 A
2 B 2 B
3 B 3 C
4 D 4 B
5 C 5 A
Learning Objective: Learning Objective:
1, 4, 7 1
QUIZ C
a Cost of goods sold
(1) $405 (25 @ $8) + (25 @ $7) + (5 @ $6)
(2) $335 (50 @ $6) + (5 @ $7)
(3) $371.25 (675 ÷ 100) x 55
b Inventory at Jan. 31:
(1) $270 ($675 – $405)
(2) $340 ($675 – $335)
(3) $303.75 (45 @ $6.75)
Learning Objective: 1
QUIZ D
a Average cost:
Inventory $7,702.50 [65 @ ($23,700 200)]
Cost of goods sold $15,997.50 ($23,700 – $7,702.50)
b First-in, first-out:
Inventory $8,325 (20 @ $135 + 45 @ $125)
Cost of goods sold $15,375 ($23,700 – $8,325)
c Last-in, first-out:
Inventory $6,875 (60 @ $105 + 5 @ $115)
Cost of goods sold $16,825 ($23,700 – $6,875)
Learning Objective: 4
Chapter 08 – Inventories and the Cost of Goods Sold
Assignment Guide to Chapter 8
Brief
Exercises
Exercises
Problems
Cases
Net
1 – 10
1-15
1
2
3
4
5
6
7
8
1
2
3
4
Time estimate (in minutes)
< 10
15
40
40
25
30
60
25
25
35
30
20
15
40
Difficulty rating
E
E
M
M
S
M
S
E
M
M
S
M
M
S
Learning Objectives:
1, 2
1, 2, 11, 12
1. In a perpetual inventory system, determine the
cost of goods sold using (a) specific identification,
(b) average cost, (c) FIFO, and (d) LIFO. Discuss
the advantages and shortcomings of each method.
2. Explain the need for taking a physical inventory.
1, 5
3. Record shrinkage losses and other year-end
adjustments to inventory.
6
1,6
4. In a periodic inventory system, determine the
ending inventory and the cost of goods sold using
(a) specific identification (b) average cost, (c)
FIFO, and (d) LIFO.
1, 2, 3, 4, 5
1, 3, 4, 7
√
5. Explain the effects on the income statement of
errors in inventory valuation.
7, 8
1, 8
6. Estimate the cost of goods sold and ending
inventory by the gross profit method and by the
retail method.
1, 9, 10
7. Compute inventory turnover rate and explain its
uses.
9, 10
1, 11, 12, 13,
14, 15