Chapter 7

Reporting and Interpreting Inventories and

Cost of Goods Sold

Learning Objectives1. Describe the issues in managing different types

of inventory.2. Explain how to report inventory and cost of

goods sold.3. Compute costs using four inventory costing

methods.4. Report inventory at the lower of cost or market.5. Analyze and record inventory purchases,

transportation, returns and allowances, and discounts.

6. Evaluate inventory management by computing and interpreting the inventory turnover ratio.

Goals of Inventory ManagementThe primary goals of inventory managers

are to: Maintain a sufficient quantity to meet

customers’ needs Ensure quality meets customers’

expectations and company standards Minimize the costs of acquiring and

carrying the inventory

Types of Inventory

Inventory includes:

1.Merchandise inventory: Goods that are held for sale in the normal course of business.

2.Manufacture inventory: Goods that are used to produce goods for sale.

Inventory includes:

1.Merchandise inventory: Goods that are held for sale in the normal course of business.

2.Manufacture inventory: Goods that are used to produce goods for sale.

Types of Inventory

Merchandiser

Manufacturer

Inventory is acquired in a finished condition and is ready for sale without further processing.

Inventory is acquired in a finished condition and is ready for sale without further processing.

Raw materials inventory includes materials that are processed further into finished goods.

Work in process inventory includes goods that are in the process of being manufactured.

Finished goods inventory includes goods that are complete and ready to sell.

Raw materials inventory includes materials that are processed further into finished goods.

Work in process inventory includes goods that are in the process of being manufactured.

Finished goods inventory includes goods that are complete and ready to sell.

Balance Sheet Reporting

Assets Current Assets Cash and Cash Equivalents 47,500$ Accounts Receivable, net 94,800 Inventories 75,800 Prepaid Expenses 16,800 Total Current Assets 234,900$

Matrix, Inc.Partial Balance SheetAt December 31, 2008

Inventory is reported on the balance sheet as a current asset because it normally is used

or converted into cash within one year.

Inventory is reported on the balance sheet as a current asset because it normally is used

or converted into cash within one year.

Income Statement Reporting

Sales, net 592,800$ Cost of Goods Sold 377,500 Gross Profit 215,300 Operating Expenses: Selling Expenses 64,500$ General and Administrative Expenses 119,400 183,900 Income Before Taxes 31,400 Income Tax Expense 9,420 Net Income 21,980$

Matrix, Inc.Income Statement

For the Year Ended December 31, 2008

Multiple-step income statement:

1. Net sales – COGS = Gross Profit.

2. Gross Profit – Operating expenses = Income before Taxes

3. Income before Taxes – Tax expense = Net income

Multiple-step income statement:

1. Net sales – COGS = Gross Profit.

2. Gross Profit – Operating expenses = Income before Taxes

3. Income before Taxes – Tax expense = Net income

+

+

Beginninginventory

Beginninginventory

Net cost ofpurchasesNet cost ofpurchases

Merchandiseavailable for sale Merchandiseavailable for sale

Ending inventoryEnding inventory Cost of goodssold

Cost of goodssold

=

Beginning B/S

Beginning B/S

Ending B/S

Ending B/S Income

StatementIncome

Statement

Cost of Goods Sold Equation

Still h

ere

Sold

QuestionRetail Company has the following amounts on

its 2008 inventory operations: Purchases, $45,000; Beginning 2008 inventory, $15,000; and Cost of goods sold, $50,000. Therefore, the 2008 ending inventory was:

a.$10,000.b.$25,000.c.$26,000.d.$27,000.

Retail Company has the following amounts on its 2008 inventory operations: Purchases, $45,000; Beginning 2008 inventory, $15,000; and Cost of goods sold, $50,000. Therefore, the 2008 ending inventory was:

a.$10,000.b.$25,000.c.$26,000.d.$27,000.

QuestionRichmond Company had the following information

taken from its 2008 inventory operations: Sales, $200; Sales Return and Allowance, $4; Beginning Inventory, $10; and Purchases, $140. A physical count of the merchandise on hand at the end of the year showed $20. Compute the gross profit that would appear in the income statement.

a.$70.b.$74.c.$66.d.$62.

Richmond Company had the following information taken from its 2008 inventory operations: Sales, $200; Sales Return and Allowance, $4; Beginning Inventory, $10; and Purchases, $140. A physical count of the merchandise on hand at the end of the year showed $20. Compute the gross profit that would appear in the income statement.

a.$70.b.$74.c.$66.d.$62.

Cost of Goods Sold Equation

Beginning inventory+ Purchases of merchandise= Cost of goods available for sale– Ending inventory= Cost of goods sold

Schedule of Cost of Goods Sold

COGS = BI + P – EI

EI = BI + P - COGS

COGS = BI + P – EI

EI = BI + P - COGS

In Feb 07, Young & Crazy Company starts from zero inventory balance and makes the following purchases:

1. One item on 2/2/07 for $10

2. One item on 2/15/07 for $15

3. One item on 2/25/07 for $20

Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow methods? Assume a tax rate of 30%.

Example

Inventory Cost Flow Methods

Inventory Cost Flow Methods May not match physical movement of

goods Allocates cost of goods available for sale

between Cost of sales Ending inventory

+

Merchandiseavailable for sale

Merchandiseavailable for sale

Ending inventoryEnding inventory Cost of goodssold

Cost of goodssold

$10+15+20=45

? ?

First-In, First-Out(FIFO)

Assumes costs flow in the order incurred.

Last-In, First-Out(LIFO)

Assumes costs flow in the reverse order incurred.

Weighted Average

Assumes costs flow at an average of the costs available.

When units are sold, the specific cost of the unit sold is added to

cost of goods sold.

Specific Identification

Inventory Cost Flow Methods

Specific Identification

When this method is used, the cost of each item sold

is individually identified and

recorded as cost of goods sold.

When this method is used, the cost of each item sold

is individually identified and

recorded as cost of goods sold.

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax Taxes Net Income

Depends on which one is sold

Specific Identification

First-In, First-Out (FIFO)

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 35

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 47 Taxes 14 Net Income $ 33

First In First Out (FIFO)

Last-In, First-Out (LIFO)

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Inventory Balance = $ 25

Purchase on 2/25/07 for $20

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 Taxes 11 Net Income $ 26

Last In First Out (LIFO)

Weighted AverageWhen a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

Cost of Goods Available for

Sale

Units on hand on the date of

sale÷

$ 45 / 3 = $15

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 30

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 12 Net Income $ 30

Weighted Average

Financial Statement Summary

FIFO LIFO Wtd. AvgSales 90$ 90$ 90$ Cost of goods sold 10 20 15

Gross profit 80 70 75

Ending Inventory Balance

302535

Comparison

Net income 302633

In periods of rising prices, FIFO results in the highest ending inventory, gross profit,

and net income, and the lowest cost of goods sold.

In periods of rising prices, FIFO results in the highest ending inventory, gross profit,

and net income, and the lowest cost of goods sold.

Financial Statement Summary

FIFO LIFO Wtd. AvgSales 90$ 90$ 90$ Cost of goods sold 10 20 15

Gross profit 80 70 75

Ending Inventory Balance

302535

Comparison

Net income 302633

In periods of rising prices, LIFO results in the lowest ending inventory, gross

profit, and net income, and the highest cost of goods sold.

In periods of rising prices, LIFO results in the lowest ending inventory, gross

profit, and net income, and the highest cost of goods sold.

Financial Statement Effects of Costing Methods

Increasing Price Decreasing Price

FIFO LIFO FIFO LIFO

Income Statement        

COGS lower higher higher lower

GROSS PROFIT higher lower lower higher

Net income higher lower lower higher

   

Balance Sheet  

Ending Inventory higher lower lower higher

Financial Statement Effects of Costing Methods

Advantages of MethodsAdvantages of Methods

Smoothes out price changes.Smoothes out price changes.

Better matches current costs in cost of goods sold with

revenues.

Better matches current costs in cost of goods sold with

revenues.

Ending inventory approximates

current replacement cost.

Ending inventory approximates

current replacement cost.

First-In, First-OutFirst-In, First-Out

Weighted Average

Weighted Average

Last-In, First-OutLast-In,

First-Out

QuestionWhen the prices are rising:

a. LIFO will result in lower net income and a higher inventory valuation than will FIFO.

b. LIFO will result in higher net income and lower inventory valuation than will FIFO.

c. FIFO will result in lower net income and a lower inventory valuation than will LIFO.

d. FIFO will result in higher net income and a higher inventory valuation than will LIFO.

When the prices are rising:

a. LIFO will result in lower net income and a higher inventory valuation than will FIFO.

b. LIFO will result in higher net income and lower inventory valuation than will FIFO.

c. FIFO will result in lower net income and a lower inventory valuation than will LIFO.

d. FIFO will result in higher net income and a higher inventory valuation than will LIFO.

Reporting Inventory at the Lower of Cost or Market

The value of inventory can fall below its recorded cost for two reasons:

1. It’s easily replaced by identical goods at

a lower cost, or

2. It’s become outdated or damaged.

The value of inventory can fall below its recorded cost for two reasons:

1. It’s easily replaced by identical goods at

a lower cost, or

2. It’s become outdated or damaged.

Reporting Inventory at the Lower of Cost or Market

When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower

market value. This is known as the lower of cost or market (LCM) rule.

This method is an application of Accounting Conservatism.

When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower

market value. This is known as the lower of cost or market (LCM) rule.

This method is an application of Accounting Conservatism.

Reporting Inventory at the Lower of Cost or Market

Pentium chips: total cost 1,000 × $250 = $250,000

total replacement cost 1,000 × $200 = $200,000

write-down $250,000 - $200,000 = $50,000

Disk drives: No write-downs.

Pentium chips: total cost 1,000 × $250 = $250,000

total replacement cost 1,000 × $200 = $200,000

write-down $250,000 - $200,000 = $50,000

Disk drives: No write-downs.

Item Quantity Cost

Replacement Cost (Market

Value) LCM Total LCMPentium chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

Reporting Inventory at the Lower of Cost or Market

Debit CreditInventory Write-down (+E, -SE) 50,000

Inventory (-A) 50,000

Accounts

Expense account, listed in the income statement as part of operating expenses.

Recording Inventory Transactions

We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will

record all inventory-related transactions in the Inventory

account.

Inventory PurchasesAmerican Eagle Outfitters purchases$10,500 of vintage jeans on credit.

1

Assets = Liabilities + Stockholders' EquityInventory –10,500 Accounts Payable +10,500

Analyze

2 Record

Transportation CostAmerican Eagle pays $400 cash to a trucker who

delivers the $10,500 of vintage jeans to one of its stores.

1

Assets = Liabilities + Stockholders' EquityCash - 400Inventory + 400

Analyze

2 Record

Purchase Returns and Allowances

American Eagle returned some of the vintage jeans to thesupplier and received a $500 reduction in the balance owed.

1

Assets = Liabilities + Stockholders' Equity

Inventory - 500 Accounts Payable - 500

Analyze

2 Record

Purchase DiscountsAmerican Eagle’s vintage jeans purchase for $10,500 had terms of 2/10, n/30. Recall that American Eagle returned

inventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within

the discount period.

1

Assets = Liabilities + Stockholders' EquityCash - 9,800 Accounts Payable -10,000Inventory -200

Analyze

2 Record

Summary of Inventory Transactions

Inventory Turnover Analysis

Comparison to Benchmarks

In class problem #1: rising price

The following information is available from the firm 's inventory record.

Units Unit CostJanuary 1, 2007 (beginning inventory) 1,500 @ $18.00Purchases:

January 5, 2007 2,500 @$18.00February 16, 2007 1,000 @$22.00March 15, 2007 1,000 @$23.00

A physical inventory count on March 31, 2007 shows 2,500 units on hand. Compute the COGS for the first three months, and the ending inventory at March 31, 2007, under each of the following inventory methods:(a) FIFO.(b) LIFO.(c) Weighted-average.

In class problem #2: decreasing price

CGL’s sales revenue is $6,000 and operating expense is $1,000. CGL’s income tax rate is 35%. Prepare income statements using following inventory cost flow method:

1. FIFO2. LIFO3. Weighted-Average method.

# of unitsPurchase price/unit

Sale price/unit

Beginning balance 100 $15

1st Purchase 500 $13

2nd Purchase 200 $10

Sale (300) $20

Ending balance 500

In class problem #3 Calculate COGS and inventory balance at the end of the year

using FIFO, LIFO and weighted average costing methods:

Beginning inventory of the year 1,000 units @ $15 each

Mar: Purchase inventory on account 3,000 units@ $18 each. Jun: Sold 2,000 units @ $30 each on account. Oct: Purchase inventory on account 2,000 units@ $21 each. Nov: Sold 1,000 units @ $32 each on account

The company uses a periodic inventory system.