PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Winston Kwok, Ph.D., CPA
Chapter 6
INVENTORIES AND
COST OF SALES
McGraw-Hill/I rwin Copyright 2011 by The McGraw-Hill Companies, I nc. All rights reserved.
6 - 2
DETERMINING INVENTORY ITEMS
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.
Items requiring special attention include:



Goods in
Transit
Goods
Damaged or
Obsolete
Goods on
Consignment
C1
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FOB Destination Point
Public
Carrier
Seller Buyer
GOODS IN TRANSIT
Public
Carrier
Seller Buyer
FOB Shipping Point
Ownership passes
to the buyer here.
C1
6 - 4
GOODS ON CONSIGNMENT
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Consignor
Consignee
Thanks for selling my
inventory in your
store.
C1
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GOODS DAMAGED OR OBSOLETE
Damaged or obsolete goods are not counted in
inventory if they cannot be sold.
Cost should be reduced to net realizable
value if they can be sold.
Net realizable value is the estimated
selling price in the ordinary course of
business less the estimated costs of
completion and the estimated costs
necessary to make the sale.
C1
6 - 6
DETERMINING INVENTORY COSTS
Invoice
Cost
Include all expenditures necessary to bring an item to
a salable condition and location.
Minus
Discounts
and
Allowances
Plus Import
Duties Plus
Freight
Plus
Storage
Plus
Insurance
C2
6 - 7
Most companies take a
physical count of
inventory at least once
each year.
INTERNAL CONTROLS AND TAKING A
PHYSICAL COUNT
When the physical count
does not match the
Merchandise Inventory
account, an adjustment
must be made.
Good internal controls over count include:
1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counts confirm existence, amount, and
quality of inventory item.
4. Second count is taken.
5. Manager confirms all items counted.
C2
6 - 8
INVENTORY COSTING UNDER
A PERPETUAL SYSTEM
Inventory
affects . . .
The matching
principle requires
matching costs
with sales.
Balance
Sheet
Income
Statement
C2
6 - 9
INVENTORY COST FLOW ASSUMPTIONS
C2
Management decisions in accounting for inventory
involve the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
6 - 10
INVENTORY COST FLOW ASSUMPTIONS
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.
P1
6 - 11
INVENTORY COSTING ILLUSTRATION
Here is information about the mountain bike inventory of Trekking
for the month of August.
P1
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SPECIFIC IDENTIFICATION
P1
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SPECIFIC IDENTIFICATION P1
Balance Sheet Inventory
Income Statement
Cost of Goods Sold
6 - 14
SPECIFIC IDENTIFICATION
Here are the entries to record the purchases and sales. The
numbers in red are determined by the cost flow assumption used.
All purchases and sales are made on credit.
The selling price of inventory was as follows:
8/14 $130
8/31 150
P1
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FIRST-IN, FIRST-OUT (FIFO)
Cost of
Goods Sold
Ending
Inventory
Oldest
Costs
Recent
Costs
P1
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FIRST-IN, FIRST-OUT (FIFO)
P1
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FIRST-IN, FIRST-OUT (FIFO)
P1
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FIRST-IN, FIRST-OUT (FIFO)
Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.
All purchases and sales are made on credit.
The selling price of inventory was as follows:
8/14 $130
8/31 150
P1
6 - 19
LAST-IN, FIRST-OUT (LIFO)
Cost of
Goods Sold
Ending
Inventory
Recent
Costs
Oldest
Costs
P1
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LAST-IN, FIRST-OUT (LIFO)
P1
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LAST-IN, FIRST-OUT (LIFO)
P1
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LAST-IN, FIRST-OUT (LIFO)
Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.
All purchases and sales are made on credit.
The selling price of inventory was as follows:
8/14 $130
8/31 150
P1
6 - 23
WEIGHTED AVERAGE
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

P1
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WEIGHTED AVERAGE
P1
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WEIGHTED AVERAGE
P1
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WEIGHTED AVERAGE
P1
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WEIGHTED AVERAGE
Here are the entries to record the purchases and sales entries for Trekking.
The numbers in red are determined by the cost flow assumption used.
All purchases and sales are made on credit.
The selling price of inventory was as follows:
8/14 $130
8/31 150
P1
6 - 28
FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Because prices change, inventory methods nearly always
assign different cost amounts.
A1
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FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Advantages of Methods
Smoothes out
price changes.
Better matches
current costs in cost
of goods sold with
revenues.
Ending inventory
approximates
current
replacement cost.
First-In,
First-Out
Weighted
Average
Last-In,
First-Out
A1
6 - 30
CONSISTENCY IN USING COSTING
METHODS
The consistency principle requires a
company to use the same accounting
methods period after period so that financial
statements are comparable across periods.
A1
6 - 31
LOWER OF COST AND NET REALIZABLE VALUE
Inventory must be reported at NRV when
NRV is lower than cost.
Can be applied two ways:
(1) separately to each
individual item.
(2) to major categories of
assets.
NRV is the estimated
selling price in the ordinary
course of business less the
estimated costs of
completion and the
estimated costs necessary
to make the sale.
Consistent with
the conservatism
principle.
P2
6 - 32
LOWER OF COST AND NRV
A motor sports retailer has the following
items in inventory:
Per Unit
Inventory Items
Units on
Hand
Cost NRV
Total Cost Total NRV
Cycles:
Roadster 20 8,000 $ 7,000 $ $ 160,000 $ 140,000
Sprint 10 5,000 6,000 50,000 60,000
Off-Road
Trax-4 8 5,000 6,500 40,000 52,000
Blazer 5 9,000 7,000 45,000 35,000
Totals
$ 295,000
P2
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LOWER OF COST AND NRV
Here is how to compute lower of cost and
NRV for individual inventory items.
P2
Lower of Cost and
NRV Applied to
Inventory Items
Units on
Hand Total Cost Total NRV
Items
Cycles:
Roadster 20 $ 160,000 $ 140,000 140,000 $
Sprint 10 50,000 60,000 50,000
Off-Road
Trax-4 8 $ 40,000 $ 52,000 40,000
Blazer 5 45,000 35,000 35,000
Totals
$ 295,000
265,000 $
6 - 34
FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS
Inventory Error Cost of Goods Sold Net Income
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated
Income Statement Effects
A2
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FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS
Inventory Error Assets Equity
Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated
Balance Sheet Effects
A2
6 - 36
INVENTORY TURNOVER
Inventory
Turnover
=
Cost of goods sold
Avg. inventory
Shows how many times a company turns over its inventory
during a period. Indicator of how well management is
controlling the amount of inventory available.
Average
Inventory
=
(Beg. Inv. + End Inv.)
2

A3
6 - 37
DAYS SALES IN INVENTORY
Reveals how much inventory is available in
terms of the number of days sales.
Days' Sales in
Inventory
=
Ending Inventory
Cost of goods sold

365
A3
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APPENDIX 6A: INVENTORY COSTING
UNDER A PERIODIC SYSTEM
P3
LIFO computation of COGS
and ending inventory under
a periodic system.
6 - 39
APPENDIX 6B:
INVENTORY ESTIMATION METHODS
P4
Inventory sometimes requires estimation for interim statements or
if some casualty such as fire or flood makes taking a physical
count impossible.
Retail Inventory Method
Gross Profit Method
6 - 40
END OF CHAPTER 6