8-1

Chapter

8 INVENTORIES AND
THE COST OF GOODS
SOLD

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-2

Inventory
Inventory Defined
Defined

Inventory
Inventory

Goods
Goods owned
owned Current
Current
and
and held
held for
for sale
sale asset
asset
to
to customers
customers

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-3

The
The Flow
Flow of
of Inventory
Inventory Costs
Costs
BALANCE SHEET

As purchase cost
Current assets:
(or manufacturing Inventory
costs) are incurred $ $
as goods
INCOME STATEMENT are sold
Revenue $
Cost of goods sold
Gross profit
Expenses
Net income
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-4

The
The Flow
Flow of
of Inventory
Inventory Costs
Costs
In a perpetual inventory system, inventory entries
parallel the flow of costs.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Entry on Purchase Date
Inventory $$$$
Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$
Inventory $$$$
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-5

Which
Which Unit
Unit Did
Did We
We Sell?
Sell?
When identical units of inventory have
different unit costs, a question naturally
arises as to which of these costs should be
used in recording a sale of inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-6

Inventory
Inventory Subsidiary
Subsidiary Ledger
Ledger
AA separate
separate subsidiary
subsidiary account
account isis maintained
maintained for
for
each
each item
item in
in inventory.
inventory.
Item LL002 Primary supplier Electronic City
Description Laser Light Secondary supplier Electric Company
Location Storeroom 2 Inventory level: Min: 25 Max: 200
Purchased Sold Balance
Cost of
Unit Unit Goods Unit
Date Units Cost Total Units Cost Sold Units Cost Total
Sept. 5 100 $ 30 $ 3,000 100 $ 30 $ 3,000
Sept. 9 75 50 3,750 100 30 3,000
75 50 3,750
Sept. 10 10 ? ? ? ? ?
? ? ?

How can we determine the unit cost for the Sept. 10 sale?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-7

Inventory
Inventory Cost
Cost Flows
Flows
We use one of these inventory valuation
methods to determine cost of inventory sold.

Specific Average
identification cost

FIFO LIFO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 Information
Information for
for the
the Following
Following Inventory
Inventory
8-8

Examples
Examples

The Bike Company (TBC)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-9

Specific
Specific Identification
Identification

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-10

Specific
Specific Identification
Identification

On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.
Nine
Nine bikes
bikes originally
originally cost
cost $91
$91 and
and 11
11 bikes
bikes
originally
originally cost
cost $106.
$106.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-11

Specific
Specific Identification
Identification

The
The Cost
Cost ofof Goods
Goods Sold
Sold for
for the
the August
August 14 14 sale
sale is
is
$1,985,
$1,985, leaving
leaving $515
$515 and
and 55 units
units in
in inventory.
inventory.

Let’s look at the entries for

Continue the Aug. 14 sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-12

Specific
Specific Identification
Identification

Retail
Retail

Cost
Cost

AA similar
similar entry
entry is
is
made Continue
made after
after each
each sale.
sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-13

Specific
Specific Identification
Identification

Cost
Cost of
of Goods
Goods
Sold
Sold for
for
August
August 3131 ==
$2,610
$2,610
Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and28.
28.
Costs
Costsassociated
associatedwith
withsales
saleson
onAugust
August31
31were
wereas
asfollows:
follows:11@
@$91,
$91,
33@@$106,
$106,15
15@
@$115,
$115,&&44@
@$119.
$119.

McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2005
 8-14

Specific
Specific Identification
Identification

Income Statement
COGS = $4,595

Balance Sheet
Inventory = $1,395 11 @@ $$106
106 == $$ 106 106
55 @@ $$115
115 == 575
575
66 @@ $$119
119 == 714
714
End.
End.Inv.
Inv. © The$McGraw-Hill
$1,395
1,395 Companies, Inc., 2005
McGraw-Hill/Irwin
 8-15
Not really. Specific
Since specific identification is hard to use
identification is so when we sell a lot of
easy, can’t we use it inventory that has lots of
all the time? different costs.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-16

Average-Cost
Average-Cost Method
Method

When a unit is sold,

the average cost of each unit
in inventory is assigned to
cost
of goods sold.

Cost of Goods Units on hand

Available for ÷ on the date of
Sale sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-17

Average-Cost
Average-Cost Method
Method

The
Theaverage
averagecost
cost per
perunit
unit
must
must be
becomputed
computedprior
prior
to
toeach
eachsale.
sale. $100 $2,500  25
$100 == $2,500 25
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-18

Average-Cost
Average-Cost Method
Method

The
The average
average costcost per
per
unit
unit is
is $100.
$100. $100 $2,500  25
$100 == $2,500 25

Let’s look at the entries

Continue for the Aug. 14 sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-19

Average-Cost
Average-Cost Method
Method

Retail
Retail

Cost
Cost

AA similar
similar entry
entry is
is
made Continue
made after
after each
each sale.
sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-20

Average-Cost
Average-Cost Method
Method

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and
August
August 28.
28.
On
OnAugust
August 31,
31, an
anadditional
additional 23
23units
unitswere
weresold.
sold.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-21

Average-Cost
Average-Cost Method
Method

$114 $3,990  35
$114 == $3,990 35

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-22

Average-Cost
Average-Cost Method
Method

The
The average
average costcost per
per $114 $3,990  35
$114 == $3,990 35
unit
unit is
is $114.
$114.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-23

Average-Cost
Average-Cost Method
Method

Income Statement
COGS = $4,622

Balance Sheet
Inventory = $1,368
$114
$114 ×× 12
12 == $1,368
$1,368
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-24

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

Oldest
Oldest Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-25

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

The
TheCost
Cost of
ofGoods
GoodsSold
Soldfor
forthe
theAugust
August 1414sale
saleis
is$1,970,
$1,970,
leaving
leaving$530
$530and
and55units
unitsin
ininventory.
inventory.
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-26

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

Retail
Retail

Cost
Cost

AA similar
similar entry
entry is
is
made Continue
made after
after each
each sale.
sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-27

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

Additional
Additionalpurchases
purchaseswere
weremade
madeon onAug.
Aug.17
17and
andAug.
Aug.28.
28.
Cost
CostOn of
of Goods
Goods
August 31,
Sold
Sold
an
for
for August
August
additional 23 units
31
31
were
=sold.
= $2,600
$2,600
On August 31, an additional 23 units were sold.

McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2005
 8-28

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

Income Statement
COGS = $4,570

Balance Sheet
22 @
@ $$115
115 == $$ 230
230
10
10 @@ $$119
119 == 1,190
1,190
Inventory = $1,420
End.
End. Inv.
Inv. $$1,420
1,420

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-29

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Recent
Recent Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-30

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

The
The Cost
Cost ofof Goods
Goods Sold
Sold for
for the
the August
August 14 14 sale
sale is
is
$2,045,
$2,045, leaving
leaving $455
$455 and
and 55 units
units in
in inventory.
inventory.
On
On August
August 14,
14, TBC
TBC sold
sold 20
20 bikes
bikes for
for $130
$130 each.
each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-31

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Retail
Retail

Cost
Cost

AA similar
similar entry
entry is
is
made Continue
made after
after each
each sale.
sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-32

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Additional
Additionalpurchases
purchaseswere
weremade
madeononAug.
Aug.17
17and
andAug.
Aug.28.
28.
On
OnAug.
Aug.31,
31,an
anadditional
additional23
23units
unitswere
weresold.
sold.

Continue © The McGraw-Hill Companies, Inc., 2005

McGraw-Hill/Irwin
 8-33

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Cost
Cost of
of Goods
Goods Sold
Sold for
for August
August 31
31 == $2,685
$2,685

Continue © The McGraw-Hill Companies, Inc., 2005

McGraw-Hill/Irwin
 8-34

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Income Statement
COGS = $4,730

Balance Sheet 55 @
@ $$ 9191 == $$ 455
455
Inventory = $1,260 77 @
@ $$115
115 == 805
805
End.
End. Inv.
Inv. $$1,260
1,260

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Inventory Valuation Methods: A Summary
Costs Allocated to: 8-35

Valuation Cost of Goods

Method Sold Inventory Comments
Specific Actual cost of Actual cost of units Parallels physical flow
identification the units sold remaining Logical method when units
are unique
May be misleading for
identical units
Average cost Number of units Number of units on Assigns all units the same
sold times the hand times the average unit cost
average unit cost average unit cost Current costs are averaged
in with older costs
First-in, First-out Cost of earliest Cost of most Cost of goods sold is based
(FIFO) purchases on recently on older costs
hand prior to the purchased units Inventory valued at current
sale costs
May overstate income during
periods of rising prices; may
increase income taxes due
Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at
(LIFO) recently purchases recent prices
purchased units (assumed still in Inventory shown at old (and
inventory) perhaps out of date) costs
Most conservative method
during periods of rising
prices; often results in lower
McGraw-Hill/Irwin © The McGraw-Hill
income taxes Companies, Inc., 2005
 8-36

The
The Principle
Principle of
of Consistency
Consistency

Once a company has

adopted a particular
accounting method, it
should follow that
method consistently,
rather than switch
methods from one
year to the next.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-37

Just-In-Time
Just-In-Time (JIT)
(JIT) Inventory
Inventory Systems
Systems

This inventory arrived just

in time for us to use it in
the manufacturing
process.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-38

Taking
Taking aa Physical
Physical Inventory
Inventory

The
The primary
primary reason
reason for
for taking
taking aa physical
physical inventory
inventory
is
is to
to adjust
adjust the
the perpetual
perpetual inventory
inventory records
records for
for
unrecorded
unrecorded shrinkage
shrinkage losses,
losses, such
such as
as theft,
theft,
spoilage,
spoilage, oror breakage.
breakage.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 LCM
LCM and
and Other
Other Write-Downs
Write-Downs
8-39

of
of Inventory
Inventory

Reduces
Reduces the the value
value
Obsolescence
Obsolescence of
of the
the inventory.
inventory.

Lower
Lower of
of Cost
Cost Adjust
Adjust inventory
inventory
or
or Market
Market value
value toto the
the lower
lower
(LCM)
(LCM) of
of historical
historical cost
cost or
or
current
current
replacement
replacement cost cost
(market).
(market).
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-40

Goods
Goods In
In Transit
Transit
AAsale
saleshould
shouldbe
berecorded
recorded when
whentitle
title
to
tothe
themerchandise
merchandisepasses
passesto
tothe
the
buyer.
buyer.

F.O.B.
F.O.B. F.O.B.
F.O.B.
shipping
shipping destination
destination
point 
point  title
title point 
point  title
title
passes
passes to to passes
passes toto
buyer
buyer at
at the
the Year buyer
buyer at
at the
the
point
point of
of End point
point of
of
shipment.
shipment. destination.
destination.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-41

Periodic
Periodic Inventory
Inventory Systems
Systems
In a periodic inventory system, inventory entries
are as follows.

Note
Note that
that an
an entry
entry is
is not
not
made
made toto inventory.
inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-42

Periodic
Periodic Inventory
Inventory Systems
Systems
In a periodic inventory system, inventory entries
are as follows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-43

Periodic
Periodic Inventory
Inventory Systems
Systems

The inventory on
hand and the
cost of goods
sold for the year
are not
determined until
year-end.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-44

Periodic
Periodic Inventory
Inventory Systems
Systems
We use one of these inventory valuation
methods in a periodic inventory system.

Specific Average
identification cost

FIFO LIFO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 Information
Information for
for the
the Following
Following Inventory
Inventory
8-45

Examples
Examples
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-46

Specific
Specific Identification
Identification

By reviewing actual
purchase invoices,
Computers, Inc. determines
that the 1,200 mouse pads
on hand at year-end have
an actual total cost of
$6,400.
Determine the cost of
goods sold for the year.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-47

Specific
Specific Identification
Identification
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept.
Cost15
of Goods 200
Sold 5.80 1,160.00
Cost
Nov. 29of Goods Sold
150 5.90 885.00
$9,725
Goods --
$9,725 $6,400
$6,400==$3,325
$3,325
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,400.00
Cost of
Goods Sold 600 $ 3,325.00
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-48

Average-Cost
Average-Cost Method
Method

The
The average
average cost
cost is
is
calculated
calculated at
at year-
year-
end
end as
as follows:
follows:

Total Cost of Total Number

Goods of Units
Available for ÷ Available for
Sale Sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-49

Average-Cost
Average-Cost Method
Method
Computers, Inc.
Mouse Pad Inventory
Avg.
Avg.Cost $9,7251,800
Cost $9,725 1,800== Date Units $/Unit Total
$5.40278
$5.40278 Beginning
Ending
EndingInventory
Inventory Inventory 1,000 $ 5.25 $ 5,250.00
Avg.
Avg.Cost $5.402781,200
Cost $5.40278 1,200== Purchases:
$6,483
$6,483 Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Cost
Costof
ofGoods
GoodsSold
Sold Sept. 15 200 5.80 1,160.00
Avg.
Avg.Cost $5.40278600
Cost $5.40278 600== Nov. 29 150 5.90 885.00
$3,242
$3,242 Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200
1,200 $ 6,483.00
?
Cost of
Goods Sold 600 $ 3,242.00
?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-50

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)

Oldest
Oldest Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-51

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)
Remember: Start Computers, Inc.
Mouse Pad Inventory
with the 11/29 Date Units $/Unit Total
purchase and then Beginning
add other purchases Inventory 1,000 $ 5.25 $ 5,250.00
until you reach the Purchases:
number of units in Jan. 3 300 5.30 1,590.00
ending inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-52

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 600@$5.25
400@$5.25
Jan. 3 300@$5.30 300@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,200
150 600

Now, we have allocated

Costs $6,575 $3,150
the cost to allNow,
1,200 let’s
Now, let’s complete
units complete the
the
Cost in
of ending inventory.
Goods Available table.
table.
for Sale $9,725

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-53

First-In,
First-In, First-Out
First-Out Method
Method (FIFO)
(FIFO)
Completing the table Computers, Inc.
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,575.00
Cost of
Goods Sold 600 $ 3,150.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-54

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)

Recent
Recent Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-55

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)
Remember: Start with Computers, Inc.
Mouse Pad Inventory
beginning inventory
Date Units $/Unit Total
and then add other Beginning
purchases until you Inventory 1,000 $ 5.25 $ 5,250.00
reach the number of Purchases:
units in ending Jan. 3 300 5.30 1,590.00
inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-56

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30
100@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,000
1,200 100
600

Now, we have allocated

Costs $6,310
Next, $3,415
Next, let’s
let’s
the cost to all 1,200 units complete
completethethe
Cost in
of ending inventory.
Goods Available for Sale $9,725
table.
table.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-57

Last-In,
Last-In, First-Out
First-Out Method
Method (LIFO)
(LIFO)
Completing the table Computers, Inc.
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,310.00
Cost of
Goods Sold 600 $ 3,415.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Importance
Importance of
of an
an Accurate
Accurate Valuation
Valuation of
of
8-58

Inventory
Inventory
Errors in Measuring Inventory
Beginning Inventory Ending Inventory
Effect on Income Statement Overstated Understated Overstated Understated
Goods Available for Sale + - NE NE
Cost of Goods Sold + - - +
Gross Profit - + + -
Net Income - + + -
Effect on Balance Sheet
Ending Inventory NE NE + -
Retained Earnings - + + -

An
Anerror
errorin
inending
endinginventory
inventoryininaayear
yearwill
willresult
result in
inthe
the
same
same error
errorin
in the
thebeginning
beginning inventory
inventory of
of the
thenext
nextyear.
year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-59

For interim fi
nancial
statements, w
e may need
to estimate e
nding
inventory an
d cost of
goods sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-60

The
The Gross
Gross Profit
Profit Method
Method

Determine
Determine cost
cost of
of goods
goods
available
available for
for sale.
sale.

Estimate
Estimate cost
cost of
of goods
goods
sold
sold by
by multiplying
multiplying the
the net
net
sales
sales by
by the
the cost
cost ratio.
ratio.

Deduct
Deduct cost
cost ofof goods
goods sold
sold
from
from cost
cost ofof goods
goods
available
available for
for sale
sale to
to
determine
determine ending
ending
inventory.
inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-61

The
The Gross
Gross Profit
Profit Method
Method
In
In March
March of of 2005,
2005, ChemCo’s
ChemCo’s inventory
inventory was
was destroyed
destroyed
by
by fire.
fire. ChemCo’s
ChemCo’s normalnormal gross
gross profit
profit ratio
ratio isis 30%
30% of
of
net
net sales.
sales. At
At the
the time
time of
of the
the fire,
fire, ChemCo
ChemCo showed showed
the
the following
following balances:
balances:

Sales
Sales $$ 31,500
31,500
Sales
Salesreturns
returns 1,500
1,500
Beginning
Beginning Inventory
Inventory 12,000
12,000
Net
Net cost
cost of
of goods
goodspurchased
purchased 20,500
20,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-62

The
The Gross
Gross Profit
Profit Method
Method
Estimating Inventory
The Gross Profit Method
Goods Available for Sale:
Beginning Inventory $ 12,000
Net cost of goods purchased 20,500
Goods available for sale $ 32,500
Less estimated cost of goods sold:
Sales $ 31,500
Less sales returns (1,500) × 70%
Net sales $ 30,000
Estimated cost of goods sold (21,000)
Estimated March inventory loss $ 11,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-63

The
The Retail
Retail Method
Method
The
The retail
retail method
method of
of estimating
estimating inventory
inventory requires
requires
that
that management
management determine
determine the the value
value of
of ending
ending
inventory
inventory at
at retail
retail prices.
prices.
In
In March
March of
of 2005,
2005, ChemCo’s
ChemCo’s inventory
inventory was
was destroyed
destroyed
by
by fire.
fire. At
At the
the time
time of
of the
the fire,
fire, ChemCo’s
ChemCo’s
management
management collected
collected the
the following
following information:
information:
Information for ChemCo
The Retail Method
Goods available for sale at cost $ 32,500
Goods available for sale at retail 50,000
Physical count of ending inventory priced at retail 22,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-64

The
The Retail
Retail Method
Method

ChemCo would follow the steps below to

estimate their ending inventory using the retail
method.

Estimating Inventory
The Retail Method
a Goods available for sale at cost $ 32,500
b Goods available for sale at retail 50,000
c Cost ratio [a b] 65%
d Physical count of ending inventory priced at retail 22,000
e Estimated ending inventory at cost [ c d] $ 14,300

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-65

Financial
Financial Analysis
Analysis

Measures
Measures howhow quickly
quickly aa company
company
sells
sells its
its merchandise
merchandise inventory.
inventory.

Average
Average Inventory
Inventory ==(Beg.
(Beg. Inv.
Inv. ++End.
End. Inv.)
Inv.) ÷÷ 22

A
A ratio
ratio that
that is
is low
low compared
compared to to competitors
competitors
suggests
suggests inefficient
inefficient use
use of
of assets.
assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 8-66

Financial
Financial Analysis
Analysis

Measures
Measures how
how manymany days
days onon
average
average itit takes
takes to
to sell
sell its
its
inventory.
inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Accounting
Accounting Methods
Methods Can
Can Affect
Affect
8-67

Financial
Financial Ratios
Ratios

Remember that identical

companies that use different
inventory methods (e.g., FIFO
and LIFO) will have different
inventory turnover ratios.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-68

Exercise
Exercise 8.2
8.2

On May 10, Hudson Computing sold 90 Millennium laptop computers to Apex Publishers.
At the date of this sale, Hudson’s perpetual inventory records included the following cost
layers for the Millennium laptops:

Purchase Date Quantity Unit Cost Total Cost

Apr. 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 $1,500 $105,000
May 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 $1,600 48,000
Total on hand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 $153,000

Prepare journal entries to record the cost of the 90 Millennium laptops sold on May 10,
assuming that Hudson Computing uses the:
a)Specific identification method (62 of the units sold were purchased on April 9, and the
remaining units were purchased on May 1).
b)Average-cost method.
c)FIFO method.
d)LIFO method.
e)Discuss briefly the financial reporting differences that may arise from choosing the FIFO
method over the LIFO method.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Exercise
Exercise 8.6
8.6 8-69

Late in the year, Software City began carrying WordCrafter, a new word processing software program. At December
31, Software City’s perpetual inventory records included the following cost layers in its inventory of WordCrafter
programs:
Purchase Date Quantity Unit Cost Total Cost
Nov. 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 $400 $3,200
Dec. 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 310 6,200
Total available for sale at Dec. 31 . . . . . . . . . . . . . . . . 28 $9,400
a)At December 31, Software City takes a physical inventory and finds that all 28 units of Word-Crafter are on
hand. However, the current replacement cost (wholesale price) of this product is only $250 per unit. Prepare the
entries to record:
1.This write-down of the inventory to the lower-of-cost-or-market at December 31. (Company policy is to
charge LCM adjustments of less than $2,000 to Cost of Goods Sold and larger amounts to a separate loss
account.)
2.The cash sale of 15 WordCrafter programs on January 9, at a retail price of $350 each. Assume that Software
City uses the FIFO flow assumption.
a)Now assume that the current replacement cost of the WordCrafter programs is $405 each. A physical
inventory finds only 25 of these programs on hand at December 31. (For this part, return to the original
information and ignore what you did in part a. )
1. Prepare the journal entry to record the shrinkage loss assuming that Software City uses the FIFO flow
assumption.
2. Prepare the journal entry to record the shrinkage loss assuming that Software City uses the LIFO flow
assumption.
3. Which cost flow assumption (FIFO or LIFO) results in the lowest net income for the period? Would using
this assumption really mean that the company’s operations are less efficient?© Explain.
The McGraw-Hill Companies, Inc., 2005
McGraw-Hill/Irwin
 Exercise
Exercise 8.8
8.8
8-70

Boswell Electric prepared the following condensed income statements for two successive years:
2011 2010
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 $1,500,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250,000 900,000
Gross profit on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 750,000 $ 600,000
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 350,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 350,000 $ 250,000

At the end of 2010 (right-hand column above), the inventory was understated by $40,000, but the
error was not discovered until after the accounts had been closed and financial statements prepared
at the end of 2011. The balance sheets for the two years showed owner’s equity of $500,000 at the
end of 2010 and $580,000 at the end of 2011. (Boswell is organized as a sole proprietorship and
does not incur income taxes expense.)

a)Compute the corrected net income figures for 2010 and 2011.
b)Compute the gross profit amounts and the gross profit percentages for each year on the basis of
corrected data.
c)What correction, if any, should be made in the amounts of the company’s owner’s equity at the end
of 2010 and at the end of 2011?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-71

Exercise
Exercise 8.9
8.9
When Laura Rapp arrived at her store on the morning of January 29, she found
empty shelves and display racks; thieves had broken in during the night and
stolen the entire inventory. Rapp’s accounting records showed that she had
inventory costing $50,000 on January 1. From January 1 to January 29, she had
made net sales of $70,000 and net purchases of $80,000. The gross profit during
the past several years had consistently averaged 45 percent of net sales. Rapp
wishes to file an insurance claim for the theft loss.

a)Using the gross profit method, estimate the cost of Rapp’s inventory at the
time of the theft.

b)Does Rapp use the periodic inventory method or does she account for
inventory using the perpetual method? Defend your answer.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Exercise
Exercise 8.13
8.13
8-72

A recent annual report of Kraft Manufacturer, Inc., reveals the following information
(dollar amounts are stated in millions):

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,542

Inventory (beginning of year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Inventory (end of year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Average time required to collect accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 22
days

a)Compute Kraft’s inventory turnover for the year.

b)Compute the number of days required by Kraft to sell its average inventory.
c)What is the length of Kraft’s operating cycle?
d)Kraft’s inventory turnover rate is much higher than the inventory turnover of a retail
computer business such as Comp USA. Explain why?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-73

Problem
Problem 8.1
8.1
On January 15, 2011, BassTrack sold 1,000 Ace-5 fishing reels to Angler’s Warehouse.
Immediately prior to this sale, BassTrack’s perpetual inventory records for Ace-5 reels included
the following cost layers:

Purchase Date Quantity Unit Cost Total Cost

Dec. 12, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 $29 $17,400
Jan. 9, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 32 28,800
Total on hand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 $46,200
a)Prepare a separate journal entry to record the cost of goods sold relating to the January 15
sale of 1,000 Ace-5 reels, assuming that BassTrack uses:
• Specific identification (500 of the units sold were purchased on December 12, and the
remaining 500 were purchased on January 9).
• Average cost.
• FIFO.
• LIFO.
b)Complete a subsidiary ledger record for Ace-5 reels using each of the four inventory
valuation methods listed above. Your inventory records should show both purchases of this
product, the sale on January 15, and the balance on hand at December 12, January 9, and
January 15.
c)Refer to the cost of goods sold figures computed in part a. For financial reporting purposes,
can the company use the valuation method that resulted in the lowest cost of goods sold if, for
tax purposes, it used the method that resulted in the highest cost of goods sold? Explain.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 Problem
Problem 8.4
8.4
8-74

Mario’s Nursery uses a perpetual inventory system. At December 31, the perpetual inventory records
indicate the following quantities of a particular blue spruce tree:
Quantity Unit Cost Total Cost
First purchase (oldest) . . . . . . . . . . . . . . . . . . . . . . . . . 130 $25.00 $ 3,250
Second purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 28.50 3,420
Third purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 39.00 3,900
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 $10,570
A year-end physical inventory, however, shows only 310 of these trees on hand. In its financial statements,
Mario’s values its inventories at the lower-of-cost-or-market. At year-end, the per-unit replacement cost of
this tree is $40. (Use $3,500 as the “level of materiality” in deciding whether to debit losses to Cost of
Goods Sold or to a separate loss account.)
Instructions
Prepare the journal entries required to adjust the inventory records at year-end, assuming that:
a. Mario’s uses: 1. Average cost. 2. Last-in, first-out.
b. Mario’s uses the first-in, first-out method. However, the replacement cost of the trees at yearend is $20
apiece, rather than the $40 stated originally. [Make separate journal entries to record (1) the shrinkage
losses and (2) the restatement of the inventory at a market value lower than cost. Record the shrinkage
losses first.]
c. Assume that the company had been experiencing monthly inventory shrinkage of 30 to 60 trees for
several months. In response, management placed several hidden security cameras throughout the
premises. Within days, an employee was caught on film loading potted trees into his pickup truck. The
employee’s attorney asked that the case be dropped because the company had “unethically used a hidden
camera to entrap his client.” Do you agree with the attorney? Defend your answer.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 8-75

Problem
Problem 8.8
8.8
Wal-Mart uses LIFO to account for its inventories. Recent financial statements were
used to compile the following information (dollar figures are in millions):
Average inventory (throughout the year). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
20,618
Current assets (at year-end) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
26,555
Current liabilities (at year-end) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
28,949
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
191,329
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
150,255
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
41,074
Average time required to collect outstanding receivables (approximate). . . . . . . . .10
days
Instructions
a.Using the information provided, compute the following measures based upon the LIFO
method: 1. Inventory turnover. 2. Current ratio 3. Gross profit rate
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
b.Assuming cost of goods sold would be lower under FIFO, what circumstances must the
 8-76

End
End of
of Chapter
Chapter 88

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005