Chapter 5

Inventory & Cost of Goods

Sold

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Income Statements – Merchandisers vs. Service Entities
• Merchandising company sells inventory, and a service company does not.
• This means that a merchandising company often has two extra lines on its
income statement before the operating expenses, that a service company
does not have: cost of goods sold and gross profit.

Service Company Merchandising Company

Income Statement Income Statement
For the Year Ended Dec. 31, 20xx For the Year Ended Dec. 31, 20xx

Service revenue $XXX Sales Revenue $XXX

Expenses Cost of goods sold XXX
Operating and Gross profit XXX
administrative expense X Operating expenses: X
Depreciation expense X Operating and administrative X
Income tax expense X expense
Net income $ X Depreciation expense X
Income tax expense $ X
Net income $ X 2
 Balance Sheets – Merchandisers vs. Service Entities

• A merchandising company will have an account called inventory

in its current asset section of the Balance Sheet.
• A service company will not have this account.

Service Company Merchandising Company

Balance Sheet Balance Sheet
As at December 31, 20XX As at December 31, 20XX

Current assets: Current assets:

Cash $X Cash $X
Short-term investments X Short-term investments X
Accounts receivable, net X Accounts receivable, net X
Prepaid expenses X Inventory X
Prepaid expenses X

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 Chapter 5’s Learning Objectives

1. Account for inventory using the perpetual and periodic

inventory systems.
2. Apply and compare three inventory costing methods.
3. Explain how accounting standards apply to inventory.
4. Compute and evaluate gross profit and inventory turnover.
5. Analyze the effects of inventory errors

• .

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Learning Objective One

Account for inventory using the perpetual

and periodic inventory systems

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 Inventory
• Inventory is the merchandise held by companies for the purpose of
being sold to customers.
• Inventory is a current asset account on the balance sheet.
• It is increased when the company purchases merchandise. (For
companies in the manufacturing sector, production costs such as
direct labor and factory overhead also increase the inventory
account. However, for illustrative purposes in this course, we will
focus on inventory accounting for a non-manufacturing company.)
• It is decreased when the company sells goods to customers.

Beginning inventory + Net purchases – Cost of goods sold

= Ending inventory

• A major accounting issue is the valuation of inventory, which

depends on the costing method used (to be discussed in Objective 2).
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 Cost of Inventory
The cost principle requires that inventory be recorded at the invoice price
plus all costs incurred to bring inventory to saleable conditions (i.e., net
purchases): every additional fees require the goods to be saleable
1. Purchase price (i.e., invoice price)
2. Freight-in
3. Insurance while in transit,
4. Any costs paid to get the inventory ready to sell (i.e., production
costs including direct labor costs)
5. Less returns
6. Less allowances, and
7. Less discounts

 All other costs (e.g., advertising, sales commission, and etc.) are
operating expenses.

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 Accounting For Inventory

• The value of inventory affects 2 financial statement accounts:

1. Inventory  reported as a current assent on the balance
sheet, and
2. Cost of goods sold (cost of sales)  reported as an
expense on the income statement.

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 Inventory and COGS

The cost of the inventory sold transfers costs out of the Inventory
account on the balance sheet to the Cost of Sales account on the
income statement when the seller delivers the goods to the buyer
(i.e., when the related revenue is recognized → matching principle).

Cost of
inventory Cost of Goods Sold (COGS)
Inventory
sold =
=
The cost of inventory sold
The cost of inventory on hand
(Expense on the Income
(Asset on the Balance Sheet)
Statement)

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 Merchandise Inventory
• Suppose a furniture store has 3 chairs in stock that cost $300 each.
• The furniture store marks the chairs up by $200 and sells 2 of the chairs
for $500 each.
• Balance sheet reports the 1 chair that the company still holds in inventory.
• Income statement reports the cost of the 2 chairs sold as shown below.
Balance Sheet (partial)
Current assets:
Cash $XXX
Accounts receivable XXX
Inventory (1 chair @ cost of $300) $300

Income Statement (partial)

Sales (2 chairs @ $500 selling price) $1,000
Cost of goods sold (2 chairs @ $300 cost) 600
Gross profit $400

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 Cost of Inventory vs. Sales Price
• Continuing with the furniture store example on slide 10: note the difference
between the cost of inventory and the sale price of inventory:

 Inventory (balance sheet) [1 chair x $300/chair = $300]

Inventory = # of inventory units on hand x Cost per unit of inventory

 Cost of Goods Sold (income statement) [2 chairs x $300/chair = $600]

COGS = # of inventory units sold x Cost per unit of inventory sold

 Sales Revenue (income statement) [2 chairs x $500/chair = $1,000]

Sales revenue = # of inventory units sold x Sale price per unit sold

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 Gross Profit (Gross Margin)

• Gross profit is the excess of sales revenue over cost of goods

sold.

Gross Profit = Sales Revenue – COGS

(income statement)

• It is called gross profit because operating expenses have not yet

been subtracted.
 Note that gross profit is only a subtotal on the Income Statement.
It is not an account.

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 Cost Flow of Inventory

All numbers are assumed for illustrative purposes:

Beginning Inventory Purchases during Cost of goods

$40K the period available for sale
(Last period’s end. $95K
$55K
Inventory – Balance Sheet)

Ending Cost of Sales

Inventory $60K
$35K (Income
(Balance Sheet) Statement)

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 Number of Units of Inventory
The number of inventory units on hand is determined from the accounting
records, backed up by a physical count of the goods at period-end. Note:

1. Consigned goods are always reported in the accounting records of the

company that owns them, regardless of where they are physically being
held for sale.
2. Companies include inventory in transit from suppliers or in transit to
customers depending on who has legal title at period-end (i.e., based
on shipping terms).

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 Shipping terms
Shipping terms, otherwise known as FOB (free on board) terms,
indicate who owns the goods at a particular time.

FOB Shipping Point FOB Destination

• Legal title passes to purchaser • Legal title passes to purchaser

when items leave seller’s place
of business.
• Purchaser pays transportation
costs.
• Purchaser owns goods while in
transit.
when items arrive at purchaser’s
receiving dock.
• Seller pays transportation costs
• Seller owns goods while in transit
 Included in seller’s inventory

 Included in purchaser’s
inventory

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