Chapter 06 – Inventory and Cost of Goods Sold
6-1
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 methods.
LO6-5 Record inventory transactions using a perpetual inventory system.
LO6-6 Apply the lower of cost and net realizable value rule 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.
Chapter 06 – Inventory and Cost of Goods Sold
6-2
Teaching Suggestions
Chapter 6 is designed to 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 students 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.
After students become 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 transactions 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 and net realizable value. The lower of cost and
net realizable value provides an easy illustration to understand the conservative nature of
generally accepted accounting principles. To the extent the estimated value of inventory falls
below its cost, inventory losses are recorded. When the estimated value of inventory rises, no
corresponding inventory gains are recorded.
The section on inventory analysis compares different inventory practices of Best Buy versus
Tiffany’s. 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 relationship
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 in the current year is the beginning balance the next year.
Chapter 06 – Inventory and Cost of Goods Sold
6-3
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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 a
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 and net realizable value
5
16
LO6-6
Explain the lower of cost and net realizable value
5
17
LO6-6
Describe the adjustment to write down inventory to
market value
5
18
LO6-6
Explain the relationship between conservatism and
the lower of cost and net realizable value for
inventory
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 the
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
Chapter 06 – Inventory and Cost of Goods Sold
6-4
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 and
net realizable value
5
BE6-15
LO6-6
Calculate ending inventory using lower of cost and
net realizable value
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 discounts 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
Chapter 06 – Inventory and Cost of Goods Sold
6-5
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 and net
realizable value
15
E6-14
LO6-6
Calculate inventory using lower of cost and net
realizable value
20
E6-15
LO6-2, 6-7
Calculate cost of goods sold, the inventory turnover
ratio, and average days in inventory
15
E6-16
LO6-2, 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 inventory purchases and sales using a
periodic system
20
E6-20
LO6-9
Find financial statement effects of understatement in
ending inventory
10
E6-21
LO6-2, 6-3,
6-5, 6-6, 6-7
Complete the accounting cycle using inventory
transactions
45
Chapter 06 – Inventory and Cost of Goods Sold
6-6
Problems
Learning
Objective(s)
Topic
Time
(Min.)
P6-1A
LO6-3
Calculate ending inventory and cost of goods sold
for four inventory methods
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
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 and net
realizable value
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 and net realizable value
20
P6-6A
LO6-2, 6-3,
6-4, 6-5, 6-6
Record transactions using a perpetual system,
prepare a partial income statement, and adjust for
the lower of cost and net realizable value
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 prepare a partial income
statement 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
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
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 and net
realizable value
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 and net realizable value
20
P6-6B
LO6-2, 6-3,
6-4, 6-5, 6-6
Record transactions using a perpetual system,
prepare a partial income statement, and adjust for
the lower of cost and net realizable value
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
6-7
P6-9B
LO6-8
Record transactions and prepare a partial income
statement using a periodic inventory system
20
P6-10B
LO6-3, 6-9
Determine the effects of inventory errors using
FIFO
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 06 – Inventory and Cost of Goods Sold
6-8
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?
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?
LO6-2
3. Which of the following levels of profitability in a multiple-step income statement represents
all revenues less all expenses?
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?
Chapter 06 – Inventory and Cost of Goods Sold
6-9
LO6-4
5. Which inventory cost flow assumption generally results in the lowest reported amount for
inventory when inventory costs are rising?
LO6-5
6. Under a perpetual inventory system:
a. Cost of good sold is recorded with a period-end adjusting entry.
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.
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?
LO6-8
9. Using a periodic inventory system, the sale of inventory on account would be recorded as:
Chapter 06 – Inventory and Cost of Goods Sold
6-10
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?
Chapter 06 – Inventory and Cost of Goods Sold
6-11
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.
2. Calculate the balance of accounts receivable and net revenue after the cash payment is
received.
3. Calculate cost of goods sold and ending inventory using the average cost method.
Solution: