Chapter 5
Inventories and Cost of
Goods Sold
After studying this chapter, students should be able to:
◼ Identify the forms of inventory held by different types of businesses and the types of costs
incurred (Module 1–LO1).
◼ Explain how wholesalers and retailers account for sales of merchandise (Module 1–LO2).
◼ Apply the inventory costing methods of specific identification, weighted average, FIFO and LIFO
by using a periodic system (Module 2–LO6).
◼ Analyze the effects of the different costing methods on inventory, net income, income taxes, and
cash flow (Module 2–LO7).
◼ Analyze the effects of an inventory error on various financial statement items (Module 3–LO8).
INSTRUCTOR’S MANUAL
5-2
Chapter Outline
MODULE 1 SALES, COST OF GOODS SOLD, AND GROSS PROFIT
Module 1
LO 1
Sales, Cost of Goods Sold, and Gross Profit
Inventory is a current asset held for resale in the normal course of business.
◼ Companies that sell inventory can be categorized into two types:
Three Types of Inventory Costs and Three Forms of Inventory
◼ Wholesalers and retailers incur a single type of cost, the purchase price of the inventory they sell.
• Cost is purchase price.
◼ Three types of manufacturing costs are incurred by a manufacturer: (Exhibit 5-1)
• Direct materials or raw materials.
Ingredients used in making a product.
• Depreciation of a factory building, supervisory salaries.
◼ Manufacturers have three forms of inventory (Exhibit 5–1):
• Direct materials or raw materials inventory: purchased materials that have not yet entered the
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5–3
Materials have entered the process and some labor costs have been incurred but the
product is not finished.
Module 1
LO 2
Net Sales of Merchandise
◼ Many retailers have a fiscal year end since they want to end their year when the busy holiday
shopping season is over.
◼ Two of the main items on the income statement are net sales and cost of goods sold.
• A service company would not report cost of goods sold since these companies do not sell
products.
Sales Returns and Allowances
◼ Sales returns.
• Return of unsatisfactory merchandise by customer.
• Cash refund or a credit against a future purchase.
Credit Terms and Sales Discounts
◼ Credit terms are special notations normally used to indicate a firm’s policy for granting credit:
1/10, n/30.
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• See EXAMPLE 5-1, Determining Whether to Take a Discount
Module 1
LO 3
Cost of Goods Sold
The Cost of Goods Sold Model
◼ The Cost of Goods Sold section of the income statement is illustrated in Exhibit 5-3.
◼ Cost of goods sold is the cost of the merchandise sold during the period.
◼ Cost of goods available for sale equals the beginning inventory plus the cost of goods purchased.
• Cost of goods sold does not include the cost of all merchandise purchased during the period,
but rather the cost of the merchandise sold during the period.
• Cost of goods available for sale is a pool of costs to be distributed between the goods that
have been sold and the goods that have not been sold and are held in ending inventory.
Inventory Systems: Perpetual and Periodic
◼ All business use one of two distinct approaches to account for inventory – periodic or perpetual
system.
◼ In a perpetual inventory system, the Inventory account is updated perpetually after each sale or
purchase of merchandise.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
• At the time of sale, inventory is decreased (credited) and cost of goods sold is increased
(debited).
• More costly to maintain but, at any point in time, the Inventory account is up to date.
Beginning and Ending Inventories in a Periodic System
In a periodic system, the Inventory account is adjusted only at the end of the year, not each time a sale or
purchase is made.
◼ Throughout the year, the Inventory account contains amount from beginning of year.
◼ Ending inventory determined by counting, and the Inventory account is updated when count is
done.
Cost of Goods Purchased (Exhibit 5-3)
◼ Purchase returns and allowances and purchase discounts are deducted from the purchases of the
period to arrive at net purchases.
◼ Cost of goods purchased equals purchases less purchase returns and allowances less purchase
discounts plus transportation in.
INSTRUCTOR’S MANUAL
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◼ Purchases – a temporary account used in a periodic inventory system to record the acquisition of
merchandise. (Example 5-4)
• It is not an asset.
◼ Purchase discounts (Example 5-5)
• A reduction in purchase price for early payment to a supplier.
• Results in a reduction of cost to purchase merchandise.
• Management must monitor purchases discounts to make sure all discounts are taken.
◼ Purchase returns and allowances
• Reduction in the cost of purchases.
• Used in a periodic inventory system when a refund is received from a supplier or a reduction
is given in the balance owed to a supplier.
• Large balance in this account may signal that the purchasing department is not buying from
reputable sources.
◼ Shipping terms and transportation costs
• According to the cost principle, all costs necessary to prepare an asset for its intended use,
including shipping costs, are included in the cost of the asset. Who pays the shipping costs is
determined by the shipping terms.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
• Seller responsible for cost of delivering merchandise to buyer.
• Part of selling expense to the seller. Classified as a selling expense on the income
statement.
• Sometimes called transportation-out.
Shipping Terms and Transfer of Title to Inventory
◼ Terms of shipment become especially important at the end of an accounting period. Need to
determine who inventory in transit belongs to. This depends on shipping terms. (Example 5-7)
Module 1
LO 4
The Gross Profit Ratio
◼ Gross Profit = Net Sales – Cost of Goods Sold
◼ Gross Profit Ratio = Gross Profit / Net Sales
• An important measure of a company’s profitability.
After deducting 60 cents for the cost of the product, the company has 40 cents on the
dollar to cover its operating costs and to earn a profit.
◼ Analyzing the Gross Profit Ratio using the Ratio Analysis Model:
1. Formulate the Question. How much of the sales revenue is used for the cost of the product?
2. Gather the Information From the Financial Statements. Net sales and cost of goods sold both
are found on the income statement.
◼ Using the Business Decision Model:
1. Formulate the Question. Would you buy stock in Gap?
2. Gather Information from the Financial Statements and Other Sources. This information will
come from a variety of sources, not limited to, but including the following:
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Alternative uses for the money.
3. Analyze the Information Gathered.
Compare gross profit ratio, with competitors, and industry averages.
MODULE 2 INVENTORY COSTING METHODS
Module 2
LO 5
Inventory Costing Methods
The choice of an inventory valuation method ultimately affects cost of goods sold and thus net income
during the period in which the inventory is sold.
◼ Assets are unexpired costs and expenses are expired costs.
◼ The value assigned to an asset on the balance sheet determines the amount eventually recognized
Inventory Costs: What Should Be Included?
◼ Inventory, like other assets, is initially recorded at cost.
◼ Cost is the price paid or consideration given to acquire an asset.
◼ As applied to inventories, cost means in principle all applicable expenditures and charges directly
or indirectly incurred in bringing an article to its existing condition and location. This includes:
Module 2
LO 6
Inventory Costing Methods with a Periodic System
Accountants make assumptions about flow of costs rather than flow of units. (Example 5-8)
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
◼ The method chosen determines not only ending inventory value but also the value allocated to cost
of goods sold.
Specific Identification Method (Example 5-9)
◼ Assumes it is possible to specifically identify which units are sold and which units are on hand.
◼ May be difficult to keep track of individual units – what if they’re nails, ping pong balls, or cans
of peas?
• Generally used where the items of inventory are unique – automobiles, appliances.
◼ An inventory costing method that relies on matching unit costs with the actual units sold.
Weighted Average Cost Method (Example 5-10)
◼ Relatively easy costing method.
◼ Assigns the same unit cost to all units available for sale during the period.
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First-In, First-Out Method (FIFO) (Example 5-11)
◼ Assigns the most recent costs to ending inventory, working backward in time.
◼ Assumes that the first units in are the first units out.
Last-In, First-Out Method (LIFO) (Example 5-12)
◼ Assigns the most recent costs to cost of goods sold.
◼ Assumes that the last units in are the first units out.
Module 2
LO 7
Selecting an Inventory Costing Method
The primary determinant should be the ability of the method to accurately reflect the net income of the
period.
Costing Methods and Cash Flow
◼ Comparative income statements comparing weighted average, FIFO, and LIFO are found in
Exhibit 5-5.
◼ Weighted average is simple; yields results between FIFO and LIFO.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5–11
Tax deferral is still beneficial since it is better to pay less tax today and more in the future
because the tax savings can be invested.
◼ To summarize the methods during a period of rising prices:
• Cost of goods sold will be higher under LIFO than FIFO.
LIFO Liquidation
◼ Occurs when a company sells more units than it purchased during the period, which can have
negative tax consequences if a company is using LIFO.
The LIFO Conformity Rule
◼ IRS requirement that when LIFO is used on a tax return, it must also be used in reporting income
to stockholders.
The LIFO Reserve: Estimating LIFO’s Effect on Income and on Taxes Paid for
Winnebago Industries (Example 5-14)
◼ The LIFO reserve is the excess of the value of ending inventory stated at FIFO over the value
stated at LIFO.
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Costing Methods and Inventory Profits
Inventory profit is the portion of gross profit that results from holding inventory during a period of rising
prices. Particularly notable with FIFO.
◼ Replacement cost is the current cost of a unit of inventory. (Example 5-15)
• Some argue that inventory should be valued at replacement cost because replacement cost is
more relevant since inventory must be replaced.
◼ Use of historical cost in valuing inventory leads to inventory profit – the portion of the gross profit
that results from holding inventory during a period of rising prices.
Changing Inventory Methods
◼ Done if company believes another method would result in better matching of expenses to
revenues.
Inventory Valuation in Other Countries
◼ Rules vary considerably throughout the world.
MODULE 3 OTHER INVENTORY ISSUES
Module 3
LO 8
Other Inventory Issues
Many different types of inventory errors exist:
◼ Mathematical.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
• Both balance sheet (inventory) and income statement (cost of goods sold and income) will be
incorrect.
◼ Incorrect ending inventory of one year, if not corrected, carries over to become erroneous
beginning inventory of the following year. (Example 5-17 and 5-18)
Module 3
LO 9
Valuing Inventory at Lower of Cost or Market
Lower-of-cost-or-market (LCM) rule: A conservative inventory valuation approach that is an attempt to
anticipate declines in the value of inventory before the actual sale.
◼ It is a departure from the cost principle.
◼ Is applied when the market value of inventory is less than its historical cost.
Why Replacement Cost is Used as a Measure of Market
◼ Replacement cost is used as measure of market value (thus we should really call it the lower–of–
cost-or–replacement-rule).
◼ Refer to Exhibit 5-7.
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Application of the LCM Rule
◼ Three different interpretations of the LCM rule are possible:
1. Report the lower of total cost or total market value for the entire inventory.
Lower-of-Cost-or-Market under International Standards
◼ Both GAAP and IFRS require LCM to value inventories. However:
MODULE 4 INVENTORY MANAGEMENT AND CASH FLOW
ISSUES
Module 4
LO 10
Inventory Management and Cash Flow Issues
A company must have a balance between having enough merchandise in stock to meet customer needs, and
incurring the high cost of carrying inventory.
◼ The inventory turnover ratio is a measure of the number of times inventory is sold during the
period.