Chapter 5

Inventories and Cost of Goods Sold

The Nature of Inventory

 Inventory is an asset held for resale rather

than use.
 Inventory is a current asset since it is sold
within one year or one operating cycle.

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The Nature of Inventory
Different Forms
Retailers and wholesalers have single inventory,
merchandise inventory.
Manufacturers have more than one form of inventory,
depending on stage of development.
Raw materials:
materials purchased items that have not yet entered
the manufacturing process.
Work in process:
process unfinished units of the company’s
product:
direct materials: used to make product
direct labor: paid to workers who make the product
from raw materials
manufacturing overhead: indirect costs
Finished goods:
goods product ready for sale.
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Merchandising Activities
A merchandise company earns profit by
buying and selling merchandise, which
consists of inventory that the company
acquire for the purpose of reselling it to
customers.
Both retailers and wholesalers are
merchandisers.

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Merchandising Activities
Typical Income Statement
Net Sales
- Cost of Goods Sold
= Gross Profit
-Operating Expenses
= Net income

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Accounting for Sales
 Revenues = Sales
Calculation of net sales
 Sales represent the total
cash and credit sales made Sales
by the merchandising Less
company.
Sales returns and
 Cash sales are recorded
allowances
daily in the journal and are
based on the total amount and Sales discounts
shown on the cash register =
tape.
 A journal entry is prepared NET SALES
each day to record sales on
credit made on that day.

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Income Statement of a Merchandiser

Cash sales $ 350,000

Credit sales 124,000
Total 474,000
Less: Sales returns &
allowances ( 12,400)

Less: Sales discounts (34,600)

Net sales $ 427,000

Contra-accounts used for

control and analysis purposes

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Sales Returns and Allowances
 Returns: to account for returned defective goods.
 cash refund.
 credit against future purchase.
 Allowance: if goods delivered were unsatisfactory
(damaged or spoiled), the customer keeps the
merchandise for a price reduction granted to customer.
 Contra revenue account: has an opposite balance to its
related account (sales revenue).
 Separate account to monitor the amount of returns and
allowances which involve the possibility of lost future
sales.

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Credit Terms & Sales
Discounts
 The credit terms for a sale describe the amounts and
timing of payments that the buyer agrees to make in
the future.
 When the credit period is long, the seller often grants
a sale discount for early payments.
 A sale discount is a reduction from the selling price
given for early payments.
 It is granted to a buyer when an invoice is paid within
a discount period.
 The discount rate and the discount period are pre-
specified in the credit terms on the invoice, along with
a credit period.

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Credit Terms and Sales Discounts
n/30 Payment due 30 days from invoice
date.

1/10, n/30 Deduct 1% of invoice amount if paid

within
10 days; otherwise full invoice
amount is
due in 30 days.

2/10, n/30 Deduct 2% of invoice amount if paid

within
10 days; otherwise full invoice
amount is
due in 30 days.
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Recording Sales Discounts (Gross
Method)

Cash 980
Sales Discounts 20
Accounts Receivable 1,000

($1,000 x 2% = $20 discount)

To record collection on account of customer who

has taken 2% sales discount.

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Sales Contra-Accounts
Sales Sales Discounts
normal normal
credit debit
balance balance

Sales Returns Sales Allowances

normal normal
debit debit
balance balance
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Accounting for Sales (Example)

 Jan 10: Sell merchandise worth $100 on

account.
 Jan 15: Refund $15 to a customer to
compensate for a quality problem.
 Jan 10: Sell merchandise worth $100 on
account 3/10,n/60. a) Payment is received
on March 10. b) Payment is received on
January, 15.

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Cost of Goods Sold (COGS)
 The cost of the goods that were sold during a period
(i.e., the matching expense figure of net sales).
 Sales revenue represents the inflow of assets
(cash & A/R), from the sale of products during
the period.
 COGS represents the outflow of an asset
(inventory) from the sale of those same
products.
 Inventory not sold (on hand) appears on the balance
sheet at the end of the fiscal year (ending inventory).
 Inventory sold apprears on the income statement as
COGS.

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Cost of Goods Sold (COGS)
 Standard format for the calculation of Cost of
Goods Sold.

Calculation of Cost of Goods Sold

Beginning inventory
+ Cost of goods purchased
= Cost of goods available for sale
- ending inventory
=Cost of Goods Sold

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Cost of Goods Sold (COGS)

Beginning Cost of Goods

Inventory Purchased
$ 15,000 $63,000

Cost of Goods
Available for
Sale
$78,000

Ending Cost of Goods

Inventory Sold
$18,000 $60,000

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Inventory Systems

Two different inventory accounting systems may be

used to collect information about the cost of the
inventory on hand and the cost of goods sold:
 Perpetual system: inventory account is updated
constantly, after every purchase or sale.
 Periodic system: inventory account is updated only
at the end of each accounting period, not each time a
sale or purchase is made.

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Perpetual Inventory Systems
 Maintained by adding the cost of each newly purchased
item to the inventory account and substracting the cost of
each item sold from the account.
 When an item is sold, its cost is recorded in the cost of
goods sold account.
 More costly to maintain.
 more record keeping in a large volume operation.
 Point of sale terminals have improved ability of mass
merchandisers to maintain perpetual systems
 Most retailers use a perpetual system for units of
inventory, but use a periodic system for cost of inventory.

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Periodic Inventory Systems
 Throughout the year, the inventory account contains the
amount of merchandise on hand at the beginning of the
year.
 The company simply records the cost of inventory in a
temporary Purchases account.
 Ending inventory is determined by counting the quantities
of merchandise on hand at the end of the period.
 Inventory records are updated periodically based on
physical inventory counts.
 Reduces record-keeping but also decreases ability to track
theft, breakage, etc. and prepare interim financial
statements.

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Accounting for Purchases: Cost of Goods Purchased

The Purchases account: temporary (closed at the

end of the period) for periodic inventory systems
only. Holding place for information used at the
end of the period to calculate the cost of goods
sold.
Calculation of Cost of Goods Purchased:
Purchases
- Purchases Returns and Allowances
- Purchase Discounts
= Net Purchases
+ Transportation In
=Cost of Goods Purchased 20
Accounting for Purchases: Cost of Goods Purchased

 Purchase Returns and Allowances

 Reductions in the cost to purchase
merchandise.
 If the merchandise received from a supplier
is defective and not acceptable, then it must
be returned.
 The purchaser may keep the imperfect but
marketable merchandise because the
supplier grants an allowance, which is a
reduction in the purchase price.
 Contra purchases account

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Accounting for Purchases:
Cost of Goods Purchased
 Purchase Discounts:
A reduction of the cost to purchase the
merchandise when merchandise is
bought on credit.
It is offered when the buyer pays for the
merchandise within the discount period.
Contra purchases account

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 Recording Purchase Discounts (Gross Method)

Account payable 500

Cash
495 Discounts
Purchase 5
($ 500 x 1% = $5 discount)

To record payment within discount period to

supplier who offers 1% purchase discount.

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Transportation Costs
 When there are transportation costs to
bring the purchased goods in, this
transportation cost is added to the
“transportation in” account.
 FOB point: place of transfer of ownership.
 FOB shipping or FOB factory vs. FOB
destination (recording issues).

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FOB Destination Point
 No sale or purchase until inventory reaches its destination.
 Ownership of inventory is transferred from the seller to the
buyer at the buyer’s place of business.
 The seller is responsible for inventory while in transit.
 The seller records costs of transportation as selling expenses
on the income statement.

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FOB Shipping Point
 Both sale and purchase are recorded upon shipment.
 Ownership is transferred from the seller to the buyer at the seller’s place of business.
 Buyer responsible for inventory while in transit
 The buyer includes the costs of transportation in the cost of goods purchased on the
income statement.

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Inventory Valuation and the Measurement
of Income
 Accounting for inventories affects both the balance sheet
and the income statement.
 Inventory is an asset (unexpired cost)
cost recorded in the
balance sheet and becomes cost of goods sold as an expense
(expired cost)
cost in the income statement when the asset is sold.
beginning inventory + COGpurchased
=
cost of goods available for sale
-
ending inventory
=
cost of goods sold
NOTE: Error in end inventory figure will give incorrect cost of goods sold,
and thus incorrect income. 27
Inventory Valuation and the Measurement
of Income

Cost of inventory includes the sum of the expenditures

and charges incurred in bringing the inventory to its
existing condition and location.
Purchase price less discounts, returns and allowances.
Transportation-in.
Insurance in transit.
Taxes.
Storage.

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Valuing Inventory
Periodic System
 The problem is to put a $ value on the items
which have been physically counted at the end
of the period.
 Inventory is purchased at different times, and at
different prices; these costs must be allocated
correctly when items are sold.
 Four methods are commonly used:
 Specific identification
 Weighted Average
 FIFO
 LIFO

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Inventory Costing Methods with a Periodic
System: Specific identification Method

 Find out exactly which items were sold; their actual cost
is cost of goods sold.
 Specific identification matches flow of costs to flow of
units.
 Impractical for most retail merchandise.
 May be difficult to keep track of individual units (what if
they are nails? Ping-pong balls? Cans of peas?).
 Can lead to income manipulation: sell selected items
(depending on their purchase price) to increase or decrease
income.

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 Inventory Costing Methods with a Periodic
System: Weighted Average Cost Method

 Assign the same unit cost to all units available for sale
during the period.
Weighted Average Cost = Cost of goods available for sale
units available for sale

 Results in smoothing of income

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Inventory Costing Methods with a Periodic
System: FIFO, or first in, first out method
Assumes that the costs of the first items
received (in most cases the beginning
inventory) are the first used to cost of
goods sold, working forward in time
through the purchased goods.
Ending inventory is reported at the most
recently paid prices, working backward in
time.

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Inventory Costing Methods with a Periodic
System: LIFO, or last in, first out method
 The opposite of FIFO.
 Assumes that the costs of the last units purchased are
the first to be used to value cost of goods sold, working
backward in time.
 Ending inventory is reported at the oldest unit costs
available (beginning inventory), working forward.

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Selecting an Inventory Costing
Method
 The primary determinant in selecting an inventory
costing method is accurate income reporting.
reporting

 Using the weighted average method, the net income

is between the amounts of FIFO and LIFO.
 Its main advantage is its simplicity.

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Selecting an Inventory Costing Method
 When prices are rising, LIFO puts higher costs in
cost of goods sold, resulting in lower income,
lower taxes. Ending inventory may be distorted
because it consists of older (earlier) costs.
 This is a deferral, not permanent savings,
in taxes because taxes will be paid later
when goods are finally sold.

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Selecting an Inventory Costing Method

 IRS has LIFO conformity rule: if a company

uses LIFO for taxes, it must also use LIFO for
financial reporting.

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Changing Method of Inventory Valuation

 Done if company believes another method

would result in better matching of revenue
and expense.
 Must be justified by other than tax
considerations.
 Must be disclosed.

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Valuing Inventory at Lower of Cost or Market

Lower of cost or market (LCM) rule is applied

when the market value of inventory is less
than its historical cost.
 Replacement cost is used as measure of
market value (thus we should call it the lower
of cost or replacement cost rule).
 It is the price a company would pay if it
bought new items to replace those in its
inventory.

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Valuing Inventory at Lower of Cost or Market

 The decline from the previously incurred cost to

replacement cost represents a loss in value.
 Report loss in the period when the market price
actually declines, not when inventory is sold.
 Loss on decline in value is « other expense » on the
income statement.
 Normal gross profit when items are sold (lower selling
price- lower cost).
 Reflects conservatism principle.
 LCM is a valid exception to the cost principle

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Analyzing The Management of Inventory
Turnover
 Inventory turnover: balance between having enough
merchandise in stock to meet customer needs, and not so
much that cash is tied up unreasonably.
 Inventory turnover ratio is used to assess how
effectively a company is managing its inventory.
Inventory Turnover ratio = Cost of Goods Sold
Average Inventory
How many times inventory is sold during a period?
Days = 360 / turnover
How many days, on average, items stay in inventory ?

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