Chapter 5 – Inventories and Cost of Goods Sold

The Nature of Inventory

• Companies that sell inventory can be broadly categorized into two types:
1. Retailers and wholesalers purchase inventory in finished form and hold it for resale.
2. Manufacturers transform raw materials into a finished product prior to sale.
• Whether a company is a wholesaler, retailer, or manufacturer, its inventory is an asset that is held
for resale in the normal course of business.
• The distinction between inventory and an operating asset is the intent of the owner.

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.
• Merchandise Inventory The account wholesalers and retailers use to report inventory held for
resale.
• Wholesalers and retailers buy merchandise in finished form and offer it for resale without
transforming the product in any way.
• Merchandise companies typically have a relatively large dollar amount in inventory – it is not
unusual for inventories to account for half the total assets of a merchandise company.
• Three types of manufacturing costs:
1. Direct materials (raw materials), are the ingredients used in making a product.
2. Direct labor consists of the amounts paid to workers to manufacture the product.
3. Manufacturing overhead includes all other costs that are related to the manufacturing process
but cannot be directly matched to specific units of output. (e.g. Depreciation of a factory
building and the salary of a supervisor).
• Raw materials: the inventory of a manufacturer before the addition of any direct labor or
manufacturing overhead (direct materials).
• The inventory of a manufacturer takes three forms:
1. Direct materials (raw materials) enter a production process in which they are transformed into
a finished product by the addition of direct labor and manufacturing overhead.
2. At any time, including the end of an accounting period, some of the materials have entered the
process and some labor costs have been incurred but the product is not finished. The cost of
unfinished products is appropriately called work in process or work in progress.
3. Inventory that has completed the production process and is available for sale is called finished
goods. Finished goods are the equivalent of merchandise inventory for a retailer or wholesaler
in that both represent the inventory of goods held for sale.
• Work in process: the cost of unfinished products in a manufacturing company (work in progress).
• Finished goods: a manufacturer’s inventory that is complete and ready for sale.
Net Sales of Merchandise
• Many merchandisers end their fiscal year on a date other than December 31.
• Retailers often choose a date toward the end of January because the busy holiday shopping season
is over, and time can be devoted to closing the records and preparing financial statements.
• Because a service company does not sell a product, it does not report cost of goods sold.
• On the income statement of a merchandising company, cost of goods sold is deducted from net
sales to arrive at gross profit, or gross margin.
• Gross profit: net sales less cost of goods sold (also called gross margin).
• Net sales: sales revenue less sales returns and allowances and sales discounts.
• Sales revenue: a representation of the inflow of assets (also called sales).

Sales Returns and Allowances

• Sales Returns and Allowances: contra-revenue account used to record refunds to customers and
reductions of their accounts.
• Most companies have standard policies that allow the customer to return merchandise within a
stipulated period of time or the customer keeps the merchandise but receives a credit for a certain
amount in the account balance.

Credit Terms and Sales Discounts

• Sales Discounts: a contra-revenue account used to record discounts given to customers for early
payment of their accounts.
• Special notation is normally used to indicate a particular firm’s policy for granting credit.
 Credit terms of n/30 mean that the net amount of the selling price is due within 30 days of the
date of the invoice.
 Net, 10 EOM means that the net amount is due anytime within ten days after the end of the
month in which the sale took place.
 Credit terms of 1/10, n/30. This means that the customer can deduct 1% from the selling price
if the bill is paid within ten days of the date of the invoice. If the customer does not pay within
the first 10 days, the full invoice amount is due within 30 days.
• Normally the discount period begins the day after the invoice date.

Cost of Goods Sold

The Cost of Goods Sold Model
• The recognition of cost of goods sold as an expense is an excellent example of the matching
principle – the company needs to match the revenue of the period with one of the most important
costs necessary to generate the revenue, the cost of the merchandise sold.
• Sales revenue represents the inflow of assets, in the form of cash and accounts receivable, from
the sale of products during the period.
• Cost of goods sold represents the outflow of an asset, inventory, from the sale of those same
products.
• Cost of goods available for sale: beginning inventory plus cost of goods purchased.
• Cost of goods sold is not necessarily equal to the cost of purchases of merchandise during the
period.
• Except in the case of a new business, a merchandiser starts the year with a certain stock of
inventory on hand, called beginning inventory.
Inventory Systems: Perpetual and Periodic
• Perpetual system: a system in which the Inventory account is increased at the time of each
purchase and decreased at the time of each sale.
• At any point during the period, the Inventory account is up to date – it has been increased for the
cost of purchases during the period and reduced for the cost of the sales.
• Periodic system: a system in which the Inventory account is updated only at the end of the period.
• Depending on the volume of inventory transactions (i.e., purchases and sales of merchandise), a
perpetual system can be extremely costly to maintain, which is why not all companies use it.
• To a certain extent, the ability of mass merchandisers to maintain perpetual inventory records has
improved with the advent of point-of-sale terminals.

Beginning and Ending Inventories in a Periodic System

• In a periodic system, the Inventory account is not updated each time a sale or purchase is made.
• Throughout the year, the periodic inventory account contains the amount of merchandise on hand
at the beginning of the year – account is adjusted only at the end of the year.
• A company using the periodic system must physically count the units of inventory on hand at the
end of the period.
• The number of units of each product is then multiplied by the cost per unit to determine the dollar
amount of ending inventory.
• One period’s ending inventory is the next period’s beginning inventory.
• Use of the periodic system reduces record keeping, but at the expense of a certain degree of
control.
• Losses of merchandise due to theft, breakage, spoilage, or other reasons may go undetected in a
periodic system because management may assume that all merchandise not on hand at the end
of the year was sold.
• In a retail store, some of the merchandise may have been shoplifted rather than sold.
• In contrast, with a perpetual inventory system, a count of inventory at the end of the period serves
as a control device.
• Companies using periodic inventory accounts cannot prepare interim financial statements
accurately, so they use estimation techniques to determine inventory for monthly or quarterly
statements.

Cost of Goods Purchased

• Two amounts are deducted from purchases to arrive at net purchases: purchase returns &
allowances and purchase discounts.
• Transportation-In: an adjunct account used to record freight costs paid by the buyer (also called
Freight-In).
• Purchases: a temporary account used in a periodic inventory system to record acquisitions of
merchandise.
• Purchases is NOT an asset account – it is included in the income statement as an integral part of
the calculation of cost of goods sold and is therefore shown as an increase in expenses and thus a
reduction in net income and stockholders’ equity.
• Purchase Returns and Allowances: a contra-purchases account 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.
• From the buyer’s standpoint, purchase returns and allowances are reductions in the cost to
purchase merchandise.
• The effect of an allowance for merchandise retained rather than returned is the same as that for
a return.
• Merchandising companies often purchase inventory on terms that allow for a cash discount for
early payment.
• To the buyer, a cash discount is called a purchase discount and results in a reduction of the cost
to purchase merchandise.
• Purchase Discounts: a contra-purchases account used to record reductions in purchase price for
early payment to a supplier. It increases net income and stockholders’ equity.
• The cost principle governs the recording of all assets.
• All costs necessary to prepare an asset for its intended use should be included in its cost – the cost
of an item to a merchandising company is not necessarily limited to its invoice price.
• The buyer does not always pay to ship the merchandise – depends on the terms of shipment.
• FOB Destination Point: terms that require the seller to pay for the cost of shipping the merchandise
to the buyer.
• FOB Shipping Point: terms that require the buyer to pay for the shipping costs.
• FOB – Free On Board.
• The total of net purchases and transportation-in is called the cost of goods purchased.

• Transportation-Out: freight costs that the seller pays when the goods are shipped FOB Destination
Point. They are necessary costs to sell the merchandise – classified as a selling expense on the
income statement.
• Terms of shipment take on additional significance at the end of an accounting period.
 If goods are shipped FOB destination point, they remain the legal property of the seller until
they reach their destination.
 Legal title to goods shipped FOB shipping point passes to the buyer as soon as the seller turns
the goods over to the carrier.
The Gross Profit Ratio
• The gross profit ratio, found by dividing gross profit by net sales, is an important measure of
profitability.
• It indicates a company’s ability to cover operating expenses and earn a profit.
• The gross profit ratio tells us how many cents on every dollar are available to cover expenses other
than cost of goods sold and to earn a profit.
• Management and other users compare the gross profit ratio with that of prior years to see if it has
increased, decreased, or remained relatively steady.
• It is important to compare the ratio with those of other companies in the same industry.
• The gross profit ratio alone is not enough to determine a company’s profitability.

Inventory Valuation & the Measurement of Income

• Assets are unexpired costs, and expenses are expired costs.
• The value assigned to an asset such as inventory on the balance sheet determines the amount
eventually recognized as an expense on the income statement.
• An error in assigning the proper amount to inventory on the balance sheet will affect the amount
recognized as cost of goods sold on the income statement.
• If the ending inventory amount is incorrect, cost of goods sold will be wrong; thus, the net income
of the period will be in error as well.

Inventory Costs: What Should Be Included?

• All assets, including inventory, are initially recorded at cost.
• Cost is defined as “the price paid, or consideration given to acquire an asset. As applied to
inventories, cost means in principle the sum of the applicable expenditures and charges directly
or indirectly incurred in bringing an article to its existing condition and location.”
• Any freight costs incurred by the buyer in shipping inventory to its place of business should be
included in the cost of the inventory.
• The cost of insurance taken out during the time that inventory is in transit should be added to the
cost of the inventory.
• The cost of storing inventory before it is ready to be sold should be included in the cost of the
inventory.
• Various types of taxes paid, such as excise and sales taxes, are other examples of costs necessary
to put the inventory into a position to be able to sell it.
• It is often difficult to allocate many of these incidental costs among the various items of inventory
purchased.

Inventory Costing Methods with a Periodic System

• For most merchandisers, the unit cost of inventory changes frequently.
• A company must use one of a number of methods available in assigning costs to ending inventory
and to cost of goods sold.
• Unless a company can specifically identify the units sold, it will need to choose among the
weighted average, FIFO and LIFO methods.
• To solve the problem of assigning costs to identical units, accountants have developed inventory
costing assumptions or methods.
Specific Identification Method
• In certain situations, it may be possible to specifically identify which units are sold and which units
are on hand.
• Specific identification method: an inventory costing method that relies on matching unit costs with
the actual units sold.
• One of two techniques can be used to find cost of goods sold:
1. Ending inventory can be deducted from the cost of goods available for sale (Cost of Goods Sold
= Cost of Goods Available for Sale – Ending Inventory).
2. Can be calculated independently by matching the units sold with their respective unit costs.
• Problems with the use of this method, because of which it is not widely used:
1. The practical difficulty of keeping track of individual items of inventory sold.
2. Allows management to manipulate income.

Weighted Average Cost Method

• Weighted average cost method: an inventory costing method that assigns the same unit cost to
all units available for sale during the period.
• The weighted average cost is calculated as follows:
Cost of Goods Available for Sale
Weighted Average Cost =
Units Available for Sale
• Ending inventory is found by: Weighted Average Cost x Number of Units in Ending Inventory
• One of two techniques can be used to find cost of goods sold:
1. Cost of Goods Sold = Cost of Goods Available for Sale – Ending Inventory
2. Cost of Goods Sold = Weighted Average Cost x Number of Units Sold
• The computation of the weighted average cost is based on the cost of all units available for sale
during the period, not just the beginning inventory or purchases.
• Each of the individual unit costs is multiplied by the number of units acquired at each price.

First-In, First-Out Method (FIFO)

• FIFO method: an inventory
costing method that assigns
the most recent costs to
ending inventory.
• The FIFO method assumes
that the first units in, or
purchased, are the first units
out, or sold.
• The first units sold during the
period are assumed to come
from the beginning inventory.
• After the beginning inventory
is sold, the next units sold are
assumed to come from the
first purchase during the
period, and so on.
Last-In, First-Out Method (LIFO)
• LIFO method: an inventory
method that assigns the
most recent costs to cost of
goods sold.
• The LIFO method assumes
that the last units in, or
purchased, are the first units
out, or sold.
• The first units sold during
the period are assumed to
come from the latest
purchase made during the
period, and so on.

Inventory Costing Methods with the Use of a Perpetual Inventory

System
• The results from using the LIFO method differ if a company uses a perpetual system rather than a
periodic system. The same is true of the weighted average method.
• The two inventory systems differ in terms of how often the Inventory account is updated:
periodically or perpetually.
• If a company uses specific identification, the results will be the same regardless of whether it uses
the periodic or perpetual system.
• To compare the periodic and perpetual systems for the other methods, we must add one
important piece of information: the date of each of the sales.

FIFO Costing with a Perpetual System

• The basic premise of FIFO applies whether a periodic or a perpetual system is used: the first units
purchased are assumed to be the first units sold.
• With a perpetual system, however, this concept is applied at the time of each sale.
• Whether the method is applied each time a sale is made or only at the end of the period, the
earliest units in are the first units out and the two systems will yield the same ending inventory
under FIFO.

LIFO Costing with a Perpetual System

• LIFO is applied every time a sale is made rather than only at the end of the year. Because of this
difference, the amount of ending inventory differs depending on which system is used.
• A gap is created with LIFO is applied on a perpetual basis – units acquired at the earliest price and
units acquired at the most recent price are on hand, but none of those at the middle price remain.
Moving Average with a Perpetual System
• Moving average: the name given to an average cost method when a weighted average cost
assumption is used with a perpetual inventory system.
• Each time a purchase is made, a new weighted average cost must be computed, thus the name
moving average.
• The ending inventory with an average cost flow differs depending on whether a periodic or a
perpetual system is used.

Selecting an Inventory Costing Method

• The choice of an inventory method will impact cost of goods sold and thus net income.
• A company should choose the method that results in the most accurate measure of net income
for the period.
• The primary determinant in selecting an inventory costing method should be the ability of the
method to accurately reflect the net income of the period.

Costing Methods and Cash Flow

• With the use of the weighted average method, net income is between the amounts for FIFO and
LIFO.
• Because operating expenses are not affected by the choice of inventory method, the lower gross
profit under LIFO results in lower income before tax, which in turn leads to lower taxes.
• During a period of rising prices, the two methods result in the following:
Item LIFO Relative to FIFO
Cost of Goods Sold Higher Lower
Gross Profit Lower Higher
Income Before Taxes Lower Higher
Taxes Lower Higher
• Lower taxes with the use of LIFO result in cash savings (in times of rising prices) – why this method
is so popular.
• The cash saved from a lower tax bill with LIFO is only a temporary savings, or what is normally
called a tax deferral.
 At some point in the life of the business, the inventory that is carried at the older, lower-priced
amounts will be sold. This will result in a tax bill higher than that under FIFO.

LIFO Liquidation
• LIFO liquidation: the result of selling more units than are purchased during the period, which can
have negative tax consequences if a company is using LIFO.
• In LIFO, the costs of the oldest units remain in inventory, and if prices are rising, the costs of these
units will be lower than the costs of more recent purchases.
• A partial or complete liquidation of the older, lower-priced units will result in a low cost of goods
sold figure and a correspondingly high gross profit for the period. In turn, the company faces a
large tax bill because of the relatively high gross profit.
• Liquidation causes the tax advantages of using LIFO to reverse on the company, which is faced
with paying off some of the taxes that were deferred in earlier periods.
The LIFO Conformity Rule
• LIFO conformity rule: the IRS requirement that when LIFO is used on a tax return, it must also be
used in reporting income to stockholders.
• The rule applies only to the use of LIFO on the tax return. A company is free to use different
methods in preparing its tax return and its income statement as long as the method used for the
tax return is not LIFO.

The LIFO Reserve

• LIFO reserve: the excess of the value of a company’s inventory stated at FIFO over the value stated
at LIFO.
• If a company decides to use LIFO, an investor can still determine how much more income the
company would have reported had it used FIFO – he or she can approximate the tax savings to the
company from the use of LIFO.
• Because the company reports inventory at a lower value on its balance sheet using LIFO, it will
report a higher cost of goods sold amount on the income statement. Thus, the LIFO reserve not
only represents the excess of the inventory balance on a FIFO basis over that on a LIFO basis but
also represents the cumulative amount by which cost of goods sold on a LIFO basis exceeds cost
of goods sold on a FIFO basis.

Costing Methods and Inventory Profits

• FIFO, LIFO, and weighted average are all cost-based methods to value inventory – they vary in
terms of which costs are assigned to inventory and which are assigned to cost of goods sold, but
all three assign historical costs to inventory.
• An alternative to assigning any of the historical costs incurred during the year to ending inventory
and cost of goods sold is to use replacement cost to value each of these.
• Replacement cost: the current cost of a unit of inventory.
• A replacement cost approach is not acceptable under current standards, but many believe that it
provides more relevant information to users.
• Inventory profit: the portion of the gross profit that results from holding inventory during a period
of rising prices.

Changing Inventory Methods

• The purpose of each of the inventory costing methods is to match costs with revenues.
• If a company believes that a different method will result in a better matching than that being
provided by the method currently being used, the company should change methods.
• A company must be able to justify a change in methods.

Inventory Valuation in Other Countries

• The acceptable methods of valuing inventory differ considerably around the world.
• Although FIFO is the most popular method in the United States, LIFO continues to be widely used,
as is the average cost method.
• Many countries prohibit the use of LIFO for tax or financial reporting purposes.
• The IASB strictly prohibits the use of LIFO by companies that follow its standards.
Inventory Errors
• If ending inventory is overstated, cost of goods sold will be understated and thus gross profit will
be overstated, resulting in the net income for the period being overstated.
• If ending inventory is understated, cost of goods sold will be overstated and thus gross profit will
be understated, resulting in the net income for the period being understated.
• The importance of inventory valuation to the measurement of income can be illustrated by
considering inventory errors.
• Many different types of inventory errors exist – can be mathematical or related specifically to the
physical count of inventory at year-end.
• The effect of a misstatement of the year-end inventory is not limited to the net income for that
year – the error also affects the income statement for the following year, because the ending
inventory of one period is the beginning inventory of the following period.
• Counterbalancing error: the effect of the overstatement of net income in the first year is offset,
or counterbalanced, by the understatement of net income by the same dollar amount in the
following year.
• The only accounts on the balance sheet affected by an inventory error are Inventory and Retained
Earnings.
• Not all errors are counterbalancing.
• Part of the auditor’s job is to perform the necessary tests to obtain reasonable assurance that
inventory has not been overstated or understated.
Valuing Inventory at Lower of Cost or Market
• This happens when inventory becomes obsolete because of market trends or other reasons and
has to be sold at a lower market price.
• 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 its actual sale.
• At the end of each accounting period, the original cost, as determined using one of the costing
methods such as FIFO, is compared with the market price of the inventory. If market is less than
cost, the inventory is written down to the lower amount.
• The adjustment reduces assets in the form of inventory and net income. The reduction in net
income is the result of reporting the Loss on Decline in Value of Inventory on the income statement
as an item of Other Expense.

Why Replacement Cost Is Used as a Measure of Market

• A better name for the lower-of-cost-or-market rule would be the lower-of-cost-or-replacement-
cost rule because accountants define market as “replacement cost.”
• The use of replacement cost as a measure of market value is subject to two constraints:
1. Market cannot be more than the net realizable value of the inventory.
2. Inventory should not be recorded at less than net realizable value less a normal profit margin.
• The use of the LCM rule serves two important functions:
1. To report the loss in value of the inventory in the year the loss occurs
2. To report in the year the shoes are actually sold the normal gross profit, which is not affected
by a change in the selling price.

Conservatism Is the Basis for the Lower-of-Cost-or-Market Rule

• The departure from the cost basis is normally justified on the basis of conservatism.
• Conservatism is “a prudent reaction to uncertainties to try to ensure that uncertainties and risks
inherent in business situations are adequately considered.”
• The write-down of the item violates the historical cost principle, which says that assets should be
carried on the balance sheet at their original cost. But the LCM rule is considered a valid exception
to the principle because it is a prudent reaction to the uncertainty involved and thus an application
of conservatism in accounting.

Application of the LCM Rule

• Three different interpretations of the rule are possible:
1. The lower of total cost or total market value for the entire inventory could be reported.
2. The lower of cost or market value for each individual product or item could be reported.
3. The lower of cost or market value for groups of items could be reported.
• A company is free to choose any one of these approaches in applying the lower-of-cost-or-market
rule.
• The item-by-item approach (Number 2) is the most popular of the three approaches – gives the
most conservative result and is the method required for tax purposes.
• Consistency is important in deciding which approach to use in applying the LCM rule.
Lower-of-Cost-or-Market under International Standards
• Both U.S. GAAP and international financial reporting standards (IFRS) require the use of the lower-
of-cost-or-market rule to value inventories.
• However, these sets of standards differ in two respects:
US GAAP IFRS
Defines market value as Uses net realizable value with
Market Value
replacement cost, subject to a no upper or lower limits
Definition
maximum and a minimum amount. imposed.
What happens in Write-downs of inventory can
future periods after be reversed in later periods – a
This new amount becomes the
inventory has been gain is recognized when the
basis for any future adjustments.
written down to a value of the inventory goes
lower market value back up.

Analyzing the Management of Inventory

• Inventory turnover ratio: a measure of the number of times inventory is sold during the period.
• Inventory is the lifeblood of a company that sells a product.
• The more quickly a company can sell—that is, turn over—its inventory, the better.
Cost of Goods Sold
• Inventory Turnover Ratio =
Average Inventory
Beginning Inventory + Ending Inventory
• Average Inventory =
2
• Management compares the current year’s turnover rate with prior years to see if the company is
experiencing slower or faster turns of its inventory.
• It is also important to compare the rate with that of other companies in the same industry.
• Number of days’ sales in inventory: a measure of how long it takes to sell inventory.
Number of Days in the Period
• Number of Days’ Sales in Inventory =
Inventory Turnover Ratio

How Inventories Affect the Cash Flows Statement

• The effects on the income statement and the statement of cash flows from inventory-related
transactions differ significantly.
• The cost of the inventory sold during the period is deducted on the income statement as cost of
goods sold.
• If the direct method is used to prepare the Operating Activities category of the statement, the
amount of cash paid to suppliers of inventory is shown as a deduction in this section of the
statement.
• If the more popular indirect method is used, it is necessary to make adjustments to net income
for the changes in two accounts: Inventory and Accounts Payable.