Chapter8_InventoriesandtheCostofGoodsSold.pdf

INVENTORIES AND THE COST OF

GOODS SOLD
Chapter 8

INCOME STATEMENT

Revenue

Cost of goods sold

Gross profit

Expenses

Net income

as goods are

sold

BALANCE SHEET

Asset

Inventory
Purchase costs

(or manufacturing

costs)

The Flow of Inventory Costs

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Entry on Purchase Date

Inventory $$$$

Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory

entries parallel the flow of costs.

The Flow of Inventory Costs

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Entry on Sale Date

Cost of Goods Sold $$$$

Inventory $$$$

When identical units of inventory have

different unit costs, a question naturally

arises as to which of these costs should

be used in recording a sale of inventory.

Which Unit Did We Sell?

Inventory Subsidiary Ledger

A separate subsidiary account is maintained for each item in
inventory.

If on March 1, Mead sells one of these Elco generators

to Boulder Construction Company for $1,800 cash and

uses Specific Identification, the company would have to

be .

Specific Identification

The Cost of Goods Sold for the March 1 sale is $1,200.

This leaves 4 units, with a total cost of $4,400, in

inventory:

2 units that cost $1,000 and 2 units that cost $1,200 each.

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit

Cost Total Units

Unit

Cost Total

Jan. 5 2 @ 1,000$ = 2,000$ 2 @ 1,000$ = 2,000$

Feb. 5 3 @ 1,200$ = 3,600$ 2 @ 1,000$

3 @ 1,200$

Mar. 1 1 @ 1,200$ 2 @ 1,000$

2 @ 1,200$

Inventory Balance

= 5,600$

= 4,400$ = 1,200$

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Mar 1 Cash 1,800

Sales 1,800

1 Cost of Goods Sold 1,200

Inventory 1,200

Retail (1 ×
$1,800)

Cost

A similar entry is made after each sale.

Specific Identification

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit

Cost Total Units

Unit

Cost Total

Jan. 5 2 @ 1,000$ = 2,000$ 2 @ 1,000$ = 2,000$

Feb.5 3 @ 1,200$ = 3,600$ 3 @ 1,200$ = 3,600$

Mar.1 1 @ 1,120$ = 1,120$ 4 @ 1,120$ = 4,480$

Inventory Balance

Average-Cost Method

The average cost per

unit must be computed

prior to each sale.

On March 1, Mead sold 1 generator for $1,800

each.

$5,600  5 = $1,120 avg. cost

Date Units Unit Cost Total Units

Unit

Cost Total Units

Unit

Cost Total

Jan. 5 2 @ 1,000$ = 2,000$ 2 @ 1,000$ = 2,000$

Feb. 5 3 @ 1,200$ = 3,600$ 2 @ 1,000$

3 @ 1,200$

Mar. 1 1 @ 1,000$ 1 @ 1,000$

3 @ 1,200$

= 5,600$

= 1,000$ = 4,600$

On March 1, Mead sold 1 generator for $1,800.

The Cost of Goods Sold for the March 1 sale is $1,000, leaving

4 units, with a total cost of $4,600, in inventory.

First-In, First-Out Method (FIFO)

Date Units Unit Cost Total Units

Unit

Cost Total Units

Unit

Cost Total

Jan. 5 2 @ 1,000$ = 2,000$ 2 @ 1,000$ = 2,000$

Feb. 5 3 @ 1,200$ = 3,600$ 2 @ 1,000$

3 @ 1,200$

Mar. 1 1 @ 1,200$ 2 @ 1,000$

2 @ 1,200$

= 5,600$

= 4,400$ = 1,200$

On March 1, Mead sold 1 generator for

$1,800.

Last-In, First-Out Method (LIFO)

The Cost of Goods Sold for the March 1 sale is $1,200,

leaving 4 units, with a total cost of $4,400, in inventory.

Inventory Valuation Methods: A Summary

Costs Allocated to:

Valuation

Method

Cost of Goods

Sold Inventory Comments

Specific Actual cost of Actual cost of units Parallels physical flow

identification the units sold remaining Logical method when units

are unique

May be misleading for

identical units

Average cost Number of units

sold times the

Number of units on

hand times the

Assigns all units the same

average unit cost

average unit cost average unit cost Current costs are averaged

in with older costs

First-in, First-out

(FIFO)

Cost of earliest

purchases on

Cost of most

recently

Cost of goods sold is based

on older costs

hand prior to the

sale

purchased units Inventory valued at current

costs

May overstate income during

periods of rising prices; may

increase income taxes due

Last-in, First-out

(LIFO)

Cost of most

recently

Cost of earliest

purchases

Cost of goods sold shown at

recent prices

purchased units (assumed still in

inventory)

Inventory shown at old (and

perhaps out of date) costs

Most conservative method

during periods of rising

prices; often results in lower

income taxes

Once a company has

adopted a particular

accounting method, it

should follow that

method consistently

rather than switch

methods from one

year to the next.

The Principle of Consistency

1. This can refer to

Purchases of raw

materials just-in-

time to process.

2. It can also refer to

completing goods

just in time to ship

to the customer.

Just-in-Time (JIT) Inventories

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31 Cost of Goods Sold $$$$

Inventory $$$$

The primary reason for taking a physical

inventory is to adjust the perpetual inventory

records for unrecorded shrinkage losses,

such as theft, spoilage, or breakage.

Taking a Physical Inventory

Reduces the value

of the inventory.
Obsolescence

Adjust inventory

value to the lower

of historical cost or

current

replacement cost

(market).

Lower of Cost

or Market

(LCM)

LCM and Other Write-Downs

of Inventory

LCM and Other Write-Downs

of Inventory

Year

End

A sale should be recorded when title to

the merchandise passes to the buyer.

F.O.B.

shipping

point  title

passes to

buyer at the

point of

shipment.

F.O.B.

destination

point  title

passes to

buyer at the

point of

destination.

Goods In Transit

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Entry on Purchase Date

Purchases $$$$

Accounts Payable $$$$

In a periodic inventory system, inventory

entries for purchases on account are as

follows:

Note that an entry is not

made to inventory.

Periodic Inventory Systems

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Entry on Sale Date

No entry to inventory.

Accounts Receivable $$$$

Sales $$$$

In a periodic inventory system, inventory

entries are as follows.

Periodic Inventory Systems

Information for the Following Inventory

Examples

Specific Identification

If specific identification is used, the company

must identify the 12 food processors on hand at

year-end and determine their actual costs from

purchase invoices. Assume that these 12 units

have an actual total cost of $1,240. The cost of

goods sold then is determined by subtracting

this ending inventory from the cost of goods

available for sale as shown:

Average-Cost Method

The average cost is determined by dividing the

total cost of goods available for sale during the

year by the total number of units available for

sale. Thus the average per-unit cost is $100

($3,000 ÷ 30 units). Under the average-cost
method, the ending inventory would be priced at

$1,200 (12 units X $100 per unit), and the cost of

goods sold would be $1,800 ($3,000 cost of

goods available for sale, less $1,200 in costs

assigned to the ending inventory).

First-In, First-Out Method (FIFO)

The cost of goods sold would be $1,550

($3,000 – $1,450).

ENDING INVENTORY

Last-In, First-Out Method (LIFO)

ENDING INVENTORY

The cost of goods sold under the LIFO method is

$2,020 ($3,000 – $980).

International Financial Reporting Standards

International
accounting
standards

prohibit the use
of LIFO.

Importance of an Accurate Valuation of

Inventory

The Gross Profit Method

1. Determine cost of goods available

for sale.

2. Estimate cost of goods sold by

multiplying the net sales by the

cost ratio.

3. Deduct cost of goods sold from

cost of goods available for sale to

determine ending inventory.

The Gross Profit Method

On January 1, Metro Hardware has a beginning inventory of
$50,000. During January, net purchase amount to $20,000
and net sales total $30,000. If Metro’s gross profit is 40%,

what is its estimated inventory on January 31?

The Gross Profit Method

Goods Available for Sale:

Beginning Inventory, Jan. 1 50,000$

Net cost of goods purchased 20,000

Cost of goods available for sale 70,000$

Deduct: Estimated cost of goods sold:

Net Sales 30,000$

Cost Ratio (100% – 40%) 60%

Estimated cost of goods sold (18,000)

Estimated ending inventory, Jan. 31 52,000$

Estimating Inventory

The Gross Profit Method

Step

1

Step

2

Step

3

The Retail Method
The retail method of estimating inventory requires that

management determine the value of ending inventory

at retail prices.

Goods available for sale at cost 450,000$

Goods available for sale at retail 1,000,000

Cost Ratio [a÷b] 45%

Physical count of ending inventory priced at retail 300,000

Estimated ending inventory at cost [c X d] 135,000

Estimating Inventory for Ski Valley

The Retail Method

Assume that Ski Valley has merchandise offered for retail sale

at $1,000,000, with a cost of $450,000 for the year. If the

ending inventory has a total retail value of $300,000, what

is the cost of the ending inventory?

(Beginning Inventory + Ending Inventory) ÷ 2

Financial Analysis

Cost of Goods Sold

Average Inventory
=

Inventory

Turnover

365

Inventory Turnover

Average Days to

Sell Inventory
=

(Beginning Inventory + Ending Inventory) ÷ 2

Financial Analysis

$50,568 6.39

$7,911 times
==

Inventory

Turnover

365 57

6.39 days
=

Average Days to

Sell Inventory
=

Financial Analysis

(Beginning Receivables + Ending Receivables) ÷ 2

Net Sales

Average Accounts Receivable
=

Receivables

Turnover

365

Receivables Turnover

Average Days to

Collect Receivables
=

THE END