PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Reporting and Interpreting Cost of Goods Sold and Inventory

Chapter 7

7-2

Flow of Inventory Costs

MerchandiseMerchandisePurchasesPurchases

Cost ofCost ofGoods SoldGoods Sold

MerchandiseMerchandiseInventoryInventory

Merchandiser

RawRawMaterialsMaterials

Raw MaterialsRaw MaterialsInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Finished GoodsFinished GoodsInventoryInventory

Cost ofCost ofGoods SoldGoods Sold

Manufacturer

DirectDirectLaborLabor

FactoryFactoryOverheadOverhead

7-3

Nature of Cost of Goods SoldBeginningBeginningInventoryInventory

PurchasesPurchasesfor the Periodfor the Period

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Goods AvailableGoods Availablefor Salefor Sale

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Beginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of goods sold

7-4

Specific Identification

When units are sold, the

specific cost of the unit sold is

added to cost of goods sold.

7-5

First-In, First-Out Method

Cost of Cost of Goods SoldGoods SoldOldest CostsOldest Costs

Ending Ending InventoryInventoryRecent CostsRecent Costs

7-6

Last-In, First-Out Method

Ending Ending InventoryInventory

Cost of Cost of Goods SoldGoods Sold

Oldest CostsOldest Costs

Recent CostsRecent Costs

7-7

Average Cost Method

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

Number of Units

Available for Sale

÷

7-8

Financial Statement Effects of Costing Methods

Advantages of Methods

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

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

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

Weighted Weighted AverageAverage

7-9

Valuation at Lower of Cost or Market

Ending inventory is reported at the lower of cost or market (LCM).

Replacement CostThe current purchase

price for identical goods.

The company will recognize a “holding” loss in the current period rather than the period in which

the item is sold.This practice is conservative.

7-10

Inventory Methods and Financial Statement Analysis

Beginning inventory FIFO- Beginning inventory LIFO

Beginning LIFO Reserve(Excess of FIFO over LIFO)

Ending inventory FIFO- Ending inventory LIFO

Ending LIFO Reserve(Excess of FIFO over LIFO)

U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis in the financial statement notes if the

FIFO values are materially different.

7-11

Perpetual and Periodic Inventory Systems

Inventory System

Item Periodic System Perpetual System

Beginning Inventory Carried over from prior period

Carried over from prior period

Add: PurchasesAccumulated in the Purchases

account

Accumulated in the Inventory

account

Less: Ending Inventory

Measured at end of period by

physical inventory count

Perpetual record updated at every

sale

Cost of Goods Sold

Computed as a residual amount at end of period

Measured at every sale based

on perpetual record

7-12

Errors in Measuring Ending Inventory

Errors in Measuring InventoryEnding Inventory Beginning Inventory

Overstated Understated Overstated Understated

Ending Inventory + - N/A N/ARetained Earnings + - - +

Goods Available for Sale N/A N/A + -Cost of Goods Sold - + + -Gross Profit + - - +Net Income + - - +

Effect on Current Period's Balance Sheet

Effect on n Current Period's Income Statement

7-13

Supplement A: LIFO LiquidationsWhen a LIFO company sells more inventory than it purchases or manufactures, items from beginning

inventory become part of cost of goods sold. This is called a LIFO liquidation.

When inventory costs are rising, these lower cost items in

beginning inventory produce a higher gross profit, higher

taxable income, and higher taxes when they are sold.

7-14

Supplement B: Additional Issues in Measuring Purchases

Purchase returns and allowances are a reduction

in the cost of purchases associated with

unsatisfactory goods.

A purchase discount is a cash discount

received for prompt payment of an account.

7-15

Supplement B: Additional Issues in Measuring Purchases

Terms

Time

Due

Discount Period

Full amountless discount

Credit Period

Full amount due

Purchase or SalePurchase or Sale 2/10,n/30Discount Percent

Number of Days Discount

Is Available

CreditPeriod

7-16

End of Chapter 7