Chapter 7

Reporting and interpreting cost of goods sold

and inventory

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

McGraw­Hill/Irwin         Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved.7-1
Understanding the Business

Provide sufficient
quantities of high-
quality inventory.
Primary Goals of
Inventory
Management
Minimize the costs of
carrying inventory.

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Items Included in Inventory

Merchandisers Manufacturing

Merchandise Raw
Inventory Materials

Work in
Process

Finished
Goods

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 Costs Included in Inventory Purchases

The cost principle requires that

inventory be recorded at the price paid
or the consideration given.

Invoice
Freight-In
Price

Inspection Preparation
Costs Costs

Any purchase returns and allowances and

purchase discounts taken are subtracted.
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Flow of Inventory Costs

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Cost of Goods Sold equation

Beginning Purchases
Inventory for the Period

Goods Available
for Sale

(Inventory (Inventory
remaining) sold)

Ending Inventory Cost of Goods Sold

(Balance Sheet) (Income Statement)

Beginning inventory + Purchases = Goods Available for Sale

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

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Perpetual and periodic inventory
systems

Perpetual Periodic

No up-to-date record
Purchase transactions
of inventory is
are recorded directly in
maintained during the
an inventory account.
year.

Sales require one

Sales require two
entry to record the
entries to record: (1)
retail sale. Cost of
the retail sale and (2)
goods sold is
the cost of goods sold.
calculated.
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Inventory Costing Methods

Inventory Costing Methods

1. Specific Identification
2. First-in, First-out (FIFO)
3. Last-in, First-out (LIFO)
4. Weighted Average
Total Dollar Amount of Goods
Available for Sale

Inventory Costing
Method

Ending Inventory Cost of Goods Sold

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Specific Identification

When units are

sold, the
specific cost of
the unit sold is
added to cost of
goods sold.

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Cost Flow Assumptions

The choice of an inventory

costing method is not based
on the physical flow of goods
on and off the shelves.

FIFO
LIFO Weighted
Average
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First-In, First-Out Method

Cost of
Oldest Costs
Goods Sold

Ending
Recent Costs
Inventory

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Last-In, First-Out method

Ending
Oldest Costs
Inventory

Cost of
Recent Costs
Goods Sold

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 Average Cost Method

When a unit is sold, the

average cost of each unit in
inventory is assigned to
cost of goods sold.
Number of
Cost of Goods
Units
Available for ÷
Available for
Sale
Sale

7-13
Perpetual inventory systems and cost
flow assumptions in practice

FIFO inventory and cost of

goods sold are the same As a consequence,
whether computed on a companies that wish to
perpetual or periodic basis. report under LIFO
convert the outputs of
their perpetual inventory
Accounting systems that keep system to LIFO with an
track of the costs of individual adjusting entry at the
items normally do so on a FIFO end of each period.
or average cost basis.

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Financial statement effects of inventory
costing methods

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 International Perspective
LIFO and International Comparisons

While U.S. GAAP allows companies to choose between FIFO,

LIFO, and weighted average inventory methods, International
Financial Reporting Standards (IFRS) currently prohibit the
use of LIFO.

GAAP allows different

IFRS requires that the
inventory accounting
same method be used for
methods to be used for
all inventory items that have
different types of inventory
a similar nature and use.
items.
These differences can create comparability problems when
one attempts to compare companies across international
borders. 7-16
 Financial Statement Effects of inventory
Costing Methods

Advantages of Methods

First-In, Last-In, Weighted

First-Out First-Out Average

Ending inventory Better matches

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

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Managers Choice of Inventory Methods

Net Income Effects Income Tax Effects

Managers prefer to report Managers prefer to pay the
higher earnings for their least amount of taxes
companies. allowed by law as late as
possible.

LIFO Conformity Rule

If last-in, first-out is used to compute
taxable income, it must also be used
to calculate inventory and cost of
goods sold for financial statements.
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Valuation at Lower of Cost or Market

Ending inventory is reported at the

lower of cost or market (LCM).

Replacement Cost
The 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.
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Internal Control of Inventory

Separation of inventory Storage in a manner that

accounting and physical protects from theft and
handling of inventory. damage.

Limiting access to Maintaining perpetual

authorized employees. inventory records.

Comparing perpetual
records to periodic
physical counts.
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Errors in Measuring Ending Inventory

Errors in Measuring Inventory

Ending Inventory Beginning Inventory
Overstated Understated Overstated Understated
Effect on Current Period's Balance Sheet
Ending Inventory + - N/A N/A
Retained Earnings + - - +
Effect on n Current Period's Income Statement
Goods Available for Sale N/A N/A + -
Cost of Goods Sold - + + -
Gross Profit + - - +
Net Income + - - +

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 Inventory and Cash Flows

Add Decrease in Inventory

Increase in Accounts
Payable

Net Income Cash Flows

from
Operations

Increase in Inventory
Decrease in Accounts
Subtract Payable

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End of Chapter 7

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