Chapter 7

Reporting and Interpreting

Inventories and
Cost of Goods Sold
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 This chapter
demonstrates how
to account for goods
purchased at
different unit costs.

2
 Learning Objectives
1. 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.

3
 Inventory Management Decisions
The primary goals of inventory managers are to:
1. Maintain a sufficient quantity of inventory to meet
customer’s needs,
2. Ensure inventory quality meets customers’
expectations and company standards, and
3. Minimize the costs of acquiring and carrying
inventory.

4
Describe the issues in
managing different
types of inventory

5
 Types of Inventory
Inventory includes goods that are:
1. Held for sale in the normal course of business, or
2. Used to produce other goods for sale.
Inventory is acquired in a finished condition
Merchandise 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
Manufacturer that are in the process of being
manufactured.
Finished goods inventory includes goods
that are complete and ready to sell.
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 Other Types of Inventory
Consignment inventory:
- refers to goods a company is holding on behalf of the
goods’ owner.
- Is reported on the balance sheet of the owner, not
the company holding the inventory.

Goods in transit:
- Inventory items being transported.
- Is reported on the balance sheet of the owner, not
the company transporting it.
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 Recall from Chapter 6…
… ownership of inventory is determined by the
terms of the inventory sales agreement…

If a sale is made FOB destination, the goods belong to the

seller until they reach their destination (the customer).

If a sale is made FOB shipping point, inventory belongs to

the customer at the point of shipping (from the seller’s
premises).

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Explain how to report
inventory and cost of
goods sold

10
Reporting Inventory on the Balance Sheet
Inventory is reported on the balance sheet as a current asset because
it normally is used or converted into cash within one year.
AMERICAN EAGLE OUTFITTERS, INC.
Balance Sheets (Partial)
At January 31, 2009 and 2008
(in millions) 2009 2008
Assets
Current Assets
Cash and Cash Equivalents $473 $116
Short-term Investments 11 504
Inventory 295 286
Accounts and Note Receivable 41 32
Prepaid Expenses and Other 105 82 11
Reporting Inventory on the Balance Sheet
When a company sells goods, it removes their cost from the
Inventory account and reports the cost on the income statement
as the expense Cost of Goods Sold

AMERICAN EAGLE OUTFITTERS, INC.

Income Statements (Partial)
For the years ended January 31, 2009, 2008 and 2007
(in millions) 2009 2008 2007
Net Sales $2,989 $3,055 $2,794
Cost of Goods Sold 1,815 1,632 1,454
Gross Profit 1,174 1,423 1,340

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 Cost of Goods Sold
Beginning Inventory + Purchases
$4,800 $10,200

Goods Available
for Sale
$15,000

Ending Inventory Cost of Goods Sold

$6,000 $9,000
(Balance Sheet) (Income Statement)

Cost of Goods sold (CGS) equation: BI + P – EI = CGS

13
 Cost of Goods Sold
Cost of Goods Sold Calculation
Beginning Inventory $4,800
+ Purchases + 10,200
Goods Available for Sale 15,000
- Cost of Goods Sold - 9,000
Ending Inventory $ 6,000

+ Inventory (A) -
Beginning Inventory 4,800
Purchases of Inventory 10,200 9,000 Cost of Goods Sold
Ending Inventory 6,000
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 Compute costs using
four inventory costing
methods

15
Inventory Costing Methods
EXAMPLE

May 3 Purchased 1 unit for $70.

May 5 Purchased 1 more unit for $75.
May 6 Purchased 1 more unit for $95.
May 8 Sold 2 units for $125 each.

Sales Revenue = $125 x 2 = $250

Cost of Goods Sold = ?

16
 Inventory Costing Methods
Based on PHYSICAL FLOWS of goods Based on ASSUMPTIONS accountants
make about the flow of inventory costs
Specific
First-in, first-out
identification
(FIFO)

- Identifies the cost of the specific item

that was sold. Last-in, first-out
- Is used when accounting for (LIFO)
individually expensive and unique items.

Weighted
If the items sold were identified as the ones average
received on May 3 and May 6:
CGS = $70 + $95 = $165
Ending Inventory = $75 17
 Inventory Costing Methods
Assumes that the inventory cost
First-in, first-out flow out in the order the goods are
(FIFO) received. CGS=?, EI=?

Assumes that the inventory cost

Last-in, first-out flow out in the opposite of the
(LIFO) order the goods are received.
CGS=?, EI=?

Uses the weighted average of the costs

Weighted of goods available for sale for both the
average cost of each item sold and those
remaining in inventory. CGS=?, EI=?
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 Inventory Cost Flow Computation
Date Description # of Units Cost per Unit Total Cost
Oct. 1 Beginning Inventory 10 $7 $ 70
Oct. 3 Purchase 30 8 240
Oct. 5 Purchase 10 10 100
Oct. 6 Sales (P=$15/unit) (35) ? ?
Ending Inventory 15 ? ?

Sales Revenue = $15 x 35 = $525

Cost of Goods Sold = ?
Ending Inventory = ?

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 First-In, First-Out (FIFO)
Oldest Costs Cost of Goods sold

Recent Costs Ending Inventory

FIFO
Beginning Inventory 10 units x $7 $ 70
+ Purchase 30 units x $8 240
10 units x $10 100
Goods Available for Sale 50 units 410
- Ending Inventory (10 x $10) + (5 x $8) 15 units 140
Cost of Goods Sold (10 x $7) + (25 x $8) 35 units $27020
 Last-In, First-Out (LIFO)
Recent Costs Cost of Goods sold

Oldest Costs Ending Inventory

LIFO
Beginning Inventory 10 units x $7 $ 70
+ Purchase 30 units x $8 240
10 units x $10 100
Goods Available for Sale 50 units 410
- Ending Inventory (10 x $7) + (5 x $8) 15 units 110
Cost of Goods Sold (10 x $10) + (25 x $8) 35 units $30021
 Weighted Average Cost
LIFO
Beginning Inventory 10 units x $7 $ 70
+ Purchase 30 units x $8 240
10 units x $10 100
Goods Available for Sale 50 units 410

Weighted Cost of Goods Available for Sale $410 $8.20

= = =
Average Cost Number of Units Available for Sale 50 units per unit

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 Weighted Average Cost
WEIGHTED AVERAGE
Beginning Inventory 10 units x $7 $ 70
+ Purchase 30 units x $8 240
10 units x $10 100
Goods Available for Sale 50 units 410
- Ending Inventory (15 x $8.20) 15 units 123
Cost of Goods Sold (35 x $8.20) 35 units $287

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 Advantages of Methods

Weighted First-In, First- Last-In, First-

Average Out Out

Ending inventory Better matches

Smooth out price approximates current costs in cost
changes. current replacement of goods sold with
cost. revenues.

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 Financial Statement Effects
Because prices change, inventory methods
nearly always assign different cost amounts.
Weighted
Effects on the Income Statement FIFO LIFO Average
Sales 525 525 525
Cost of goods sold 270 300 287
Gross profit 255 225 238
Operating expenses 125 125 125
Income from Operations 130 100 113
Other Revenue (Expenses) 20 20 20
Income before Income Tax Expense 150 120 133
Income tax expense (30%) 45 36 40
Net income 105 84 93
Effects on the Balance Sheet
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Inventory $ 140 $ 110 $ 123
 Financial Statement Effects
Effect of Increasing Cost on the Financial Statements
FIFO LIFO
Inventory (Balance Sheet) Higher Lower
Cost of Goods Sold (Income Statement) Lower Higher

Effect of Decreasing Cost on the Financial Statements

FIFO LIFO
Inventory (Balance Sheet) Lower Higher
Cost of Goods Sold (Income Statement) Higher Lower

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Tax Implications and Cash Flow Effects
Weighted
Effects on the Income Statement FIFO LIFO Average
Sales 525 525 525
Cost of goods sold 270 300 287
Gross profit 255 225 238
Operating expenses 125 125 125
Income from Operations 130 100 113
Other Revenue (Expenses) 20 20 20
Income before Income Tax Expense 150 120 133
Income tax expense (30%) 45 36 40
Net income 105 84 93
Effects on the Balance Sheet
Inventory $ 140 $ 110 $ 123

When faces with increasing costs per unit, a company

that uses FIFO will have a higher income tax expenses.
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 Consistency in Reporting
Are managers free to choose LIFO one period, FIFO the
next, and then back to LIFO, depending on whether unit
costs are rising or declining during the period???
 Because this constant switching could make it difficult to compare
financial results across periods, accounting rules discourage it.

 A change in method is allowed only if it will improve the accuracy

with which the company’s financial results and financial position are
measured.

 A company can, however, use different methods for inventories that

differ in nature or use, provided that the methods are used consistently
over time. 28
Report inventory at
the lower of cost or
market

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 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.

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 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.

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 Ethical Insights

Financial statements are used by outsiders to make

decisions and accountants don’t want to mislead
them.

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 Lower of Cost or Market
Market LCM
Cost per Total Write-
Item Value per per Quantity Total LCM
Item Cost down
Item Item
Leather 1,000 x $150 =
coats
$165 $150 $150 1,000
$150,000
$165,000 $15,000

Vintage
jeans
20 25 20 400 400 x $20 = 8,000 8,000 0

Analyze
Assets = Liabilities + Stockholders' Equity
Inventory -15,000 = Cost of Goods Sold (+E) -15,000

Record Accounts Debit Credit

Cost of Goods Sold (+E, -SE) 15,000
Inventory (-A) 15,000
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 Analyze and record
inventory purchases,
transportation, returns
and allowances, and
discounts

34
 Inventory Purchases
Example: American Eagle Outfitters purchases $10,500 of
vintage jeans on credit.

Analyze
Assets = Liabilities + Stockholders' Equity
Inventory +10,500 = Accounts Payable +10,500

Record Accounts Debit Credit

Inventory (+A) 10,500
Accounts Payable (+L) 10,500

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 Transportation Cost
Example: American Eagle Outfitters pays $400 cash to a trucker
who delivers the $10,500 of vintage jeans to one of its stores.

Analyze
Assets = Liabilities + Stockholders' Equity
Cash -400 =
Inventory +400

Record Accounts Debit Credit

Inventory (+A) 400
Cash (-A) 400
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 Purchase Returns and Allowances
When goods purchased from a supplier arrive in damaged
condition or fail to meet specifications, the buyer can:
1. Return them for a full refund, or
2. Keep them and ask for a cost reduction, called allowance.

Purchase Returns and Allowances

A reduction in the cost of inventory purchases
associated with unsatisfactory goods
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 Purchase Returns and Allowances
Example: American Eagle Outfitters returned some of the
vintage jeans to the supplier and received a $500 reduction in
the balance owed.
Analyze
Assets = Liabilities + Stockholders' Equity
Inventory -500 Accounts Payable -500

Record Accounts Debit Credit

Accounts Payable (-L) 500
Inventory (-A) 500
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 Purchase Discounts
Purchase discount: A cash discount received for prompt
payment of a purchase on account.
Number of days in Purchase cost
discount period (after returns and allowances)

Discount
percentage
offered 2/10, n/30 Maximum
credit period

2% discount
period

November 1 November 10 November 30

Date of End of discount End of credit
purchase period period
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 Purchase Discounts
Example: American Eagle Outfitter purchased vintage jeans
for $10,500 with terms 2/10, n/30 on credit, returned $500,
then paid within 10 days of the purchase date.
Analyze
Assets = Liabilities + Stockholders' Equity
Cash -9,800 * = Account Payable -10,000
Inventory -200 **
** 2% x $10,000 = $200
* $10,000 – 200 = $9,800

Accounts Debit Credit

Record Accounts Payable (-L) 10,000
Cash (-A) 9,800
Inventory (-A) 40200
 Summary of Inventory Transactions
Beginning Inventory $4,800
+ Purchases $10,500
+ Freight-in 400
- Purchase Returns and Allowances (500)
- Purchase Discounts (200)
Net Purchases 10,200
Cost of Goods Available for Sale $15,000

dr + Inventory (A) cr -
Beginning Inventory 4,800
Purchases of Inventory 10,500 500 Purchase Returns
Freight-in 400 200 Purchase Discounts
Ending Inventory 15,000 41
 Evaluate inventory
management by computing
and interpreting the
inventory turnover ratio

42
 Inventory Turnover Analysis
Inventory Turnover Ratio
The Inventory Turn Over Ratio measures the efficiency of
inventory management. It reflects how many times
average inventory was bought and sold during the period.

Inventory
Cost of Goods Sold
Turnover = Average Inventory
Ratio

Beginning Ending
Inventory + Inventory
2 43
 Inventory Turnover Ratio
 A higher ratio indicates that inventory moves more quickly from
purchase to sale, reducing storage and obsolescence costs.

 Because less money is tied up in inventory, the excess can be

invested to earn interest or reduce borrowing, which reduces
interest expense.

 More efficient purchasing and production techniques as well as

high product demand will boost this ratio.

 A sudden decline in the inventory turnover ratio may signal an

unexpected drop in demand for the company’s products or
sloppy inventory management.
44
 Inventory Turnover Analysis
Days to sell

Days to 365
=
Sell Inventory Turnover Ratio

A measure of the average number of days from the

time inventory is bought to the time it is sold. A
higher number means a longer time to sell
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 Comparison to Benchmarks
Inventory turnover ratios and the number of days to sell can
be helpful in:

 Comparing different companies’ inventory management

practices, but use them cautiously because these measures
can vary significantly between industries and between
companies within the same industry.

 Comparing a company’s turnover with its own results from

prior periods.

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 Homework
• Demonstration case: Ebert Electronics (p. 331)
– Must read
– Try to answer all questions
– Check your answers with solutions
• Exercises:
- Multiple choice: 1-10 (p. 335)
- E7: 1, 5, 6(1-3), 10, 13, and 18 (pp. 338-344)

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End of Chapter 7

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