Inventory Book (Intermediate Accounting)

CHAPTER
Inventory and the Cost of Sales

8
LO1 LO2 LO3
Counting
Accounting for
Inventory and Cost Inventory Inventory and
of Goods Sold Calculating
Purchases and
Cost of Goods
Sales
Sold
LO4 LO5
Valuing and
Cost Formulas Reporting
Inventory at the
for Inventory
Lower of Cost or
Net Realizable
Value
CHAPTER
Inventory and the Cost of Sales
8
LO6 LO7 LO8 LO9

Assessing How Complications of
LIFO Cost Methods of
Well Companies the Perpetual
Formula Estimating
System with LIFO
Manage Their Inventories
and Weighted
Inventories Average Cost
LO1 Inventory and Cost of Goods Sold
What is Inventory?
Inventory
► Goods held for resale.
Cost of Goods Sold
► The costs incurred to purchase or manufacture the
merchandise sold during a period.
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 4
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
LO1
What is Inventory?
Activity: Buying/Making and Selling Inventory
Exhibit 8.2
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
LO1
What is Inventory?
Inventory
Three different types of inventory in a manufacturing
company
► Raw materials: materials purchased for use in
manufacturing process.
► Work in process: partially completed units in
production.
► Finished goods: manufactured products ready for sale.
LO1
What is Inventory?
Costs Included in Inventory Cost
Inventory cost consists of all costs involved in buying the
inventory and preparing it for sale.
► Raw materials
► Labor costs
► Manufacturing overhead: The indirect manufacturing
costs associated with producing inventory.
Those costs incurred in the sales
► Freight-in costs effort itself are not inventory costs,
but instead should be reported as
operating expenses in the period in
which they are incurred.
LO1
Who Owns the Inventory?
Goods Being Shipped

► FOB (free-on-board) destination
► FOB (free-on- board) shipping point
Exhibit 8.3
LO1
Who Owns the Inventory?
Goods on Consignment
► The consignors provide inventory to consignee for
resale while retain ownership of the inventory until it
is sold.
consignor consignee
Keeping
ownership
LO1
Ending Inventory and Cost of Goods Sold
Cost of Goods Available for Sale
Beginning Inventory Cost of Goods

+ =
inventory purchased Available for Sale
The Cost Allocation Process

Ending
inventory
Cost of Goods
Available for Sale
Cost of
Goods sold
LO2 Accounting for Inventory Purchases and Sales
Perpetual vs. Periodic System
Perpetual Inventory System

► Detailed records of the number of units and the cost of
each purchase and sale are prepared
THROUGHOUT the period.
Periodic Inventory System
► System of accounting where cost of goods sold is
determined and inventory is adjusted at the END of the
accounting period, not when merchandise is
purchased or sold.
LO2
Illustration-Purchases
► Followings are transactions of Grantsville Clothing
Store:
a. Purchased on account: 1,000 shirts at a cost of $10
each for a total of $10,000.
b. Purchased on account: 300 pairs of pants at a cost of
Perpetual $18 each for a total ofPeriodic
$5,400.
a. Inventory 10,000 Purchases 10,000
Accounts Payable 10,000 Accounts Payable 10,000
b. Inventory 5,400 Purchases 5,400
Accounts Payable 5,400 Accounts Payable 5,400
LO2
Illustration-Transportation Costs
c. Paid cash for separate shipping costs on the shirts
purchased in (a), $970.
Perpetual Periodic
c. Inventory 970 Freight In 970
Cash 970 Cash 970
LO2
Illustration-Purchase Return
d. Returned 30 of the shirts (costing $300) to the
supplier because they were stained.
Perpetual Periodic
d. Accounts Payable 300 Accounts Payable 300
Inventory 300 Purchase Returns 300
LO2
Illustration-Purchase Discounts
e. Paid for the shirt purchase. A 2% discount was given
on the $9,700 bill [(1,000 purchased − 30 returned) ×
$10] because of payment within the 10-day discount
period (payment terms were 2/10, n/30).
Perpetual Periodic
e. Accounts Payable 9,700 Accounts Payable 9,700
Inventory 194 Purchase Discounts 194
Cash 9,506 Cash 9,506
LO2
Illustration-Purchase Discounts
f. Paid $5,400 for the pants purchase. No discount was
allowed because payment was made after the
discount period.
Perpetual Periodic
f. Accounts Payable 5,400 Accounts Payable 5,400
Cash 5,400 Cash 5,400
LO2
Illustration-Sale
g. Sold on account: 600 shirts at a price of $25 each for
a total of $15,000.
Perpetual Periodic
g. Accounts Receivable 15,000 g. Accounts Receivable 15,000
Sales (600 x $25) 15,000 Sales 15,000

Cost of Goods Sold 6,000
6,000
Inventory(600x$10)
LO2
Illustration-Sale
h. Sold on account: 200 pairs of pants at a price of $40
each for a total of $8,000.
Perpetual Periodic
h. Accounts Receivable 8,000 Accounts Receivable 8,000
Sales (200 x $40) 8,000 Sales 8,000
Inventory (200 x 3,600
$18)
► Under periodic system, Grantsville would not even know

how many shirts and how many pairs of pants had been
sold. Only total sales of $23,000 would be known.
LO2
Illustration-Sale
► The cost of goods sold for the shirts recorded here is
$10 each. The actual cost per shirt, after adjusting for
freight in and purchase discounts, is $10.80, computed
as follows:
Total purchase price (1,000 shirts) $10,000
Plus: Freight in 970
Less: Purchase returns (30 shirts) (300)
Less: Purchase discounts (194)
Total cost of shirts (970 shirts) $10,476
Total cost $10,476 ÷ 970 shirts = $ 10.80 per shirt
LO2
Illustration-Sale Returns
i. Accepted return of 50 shirts by dissatisfied customers.
Perpetual Periodic
i. Sales Returns (50 x $25) 1,250 Sales Returns 1,250
Accounts Receivable 1,250 Accounts Receivable 1,250
Inventory (50 x $10) 500

Cost of Goods Sold 500
LO2
Illustration-Closing Entries
► Perpetual System
(Ending) Inventory Cost of goods

on the B/S sold on the S/CI
LO2
► Periodic System: the correct balances can only be
determined after an actual count of the ending
inventory.
► Step 1: Transfer all the temporary account balance to
the inventory account. Net Purchases
Inventor 15,876
yPurchase 300
Returns
Purchase 194
Discounts
Freight In 970
Purchases 15,400
Closing of temporary inventory accounts for periodic system.
LO2
► Step 2: Reduce Inventory by the amount of Cost of
Goods Sold.
The year-end physical count: $6,776

Inventory ($15,876 – $6,776) 9,100
Adjustment of inventory account to appropriate ending balance.
LO2
Quiz Yourself
◆ For each of the following businesses, indicate whether

the business would be more likely to use a perpetual
or a periodic inventory system.
Solution
LO3 Counting Inventory and Calculating Cost of Goods Sold
Taking a Physical Count of Inventory
Periodic System
► A physical count is the only way to get the information
necessary to compute cost of goods sold.
Perpetual System
► Physical counts allow companies to determine inventory
shrinkage.
Two Steps for Physical Count of Inventory
► Quantity count
► Inventory costing
LO3
Illustration
Periodic Perpetual
System System
Beginning inventory $ 0 $ 0 From
Physical inventory
Plus: Net purchases count 15,876 15,876 system
Cost of goods available for sale $15,876 $ 15,876
Less: Ending inventory 5,950 6,776
Cost of goods sold $ 9,926 $ 9,100
Goods lost or stolen unknown 826
Total cost of goods sold, lost, or stolen $ 9,926 $ 9,926
$6,776 – $5,950
LO3
Illustration-Perpetual Inventory System

► The adjusting entry needed to record the inventory
shrinkage when using a perpetual inventory system
is as follows:
Inventory shrinkage
Cost of Goods Sold 826

Inventory ($6,776 – $5,950) 826
Adjustment of perpetual inventory balance to reflect inventory shrinkage.
LO3
Illustration-Periodic Inventory System

► With a periodic inventory system, no journal entry for
inventory shrinkage is made because the amount of
shrinkage is unknown.
► Using the $5,950 ending inventory amount, the
appropriate periodic inventory closing entry is:

Inventory ($15,876 – $5,950) 9,926
Adjustment of inventory account to appropriate ending balance.
LO3
Inventory Errors
Illustration
► Assume the following correct data for Salina
Corporation:
LO3
Effects of an Ending Inventory Error on
Current and Next Periods*
Illustration
► Now suppose that ending inventory in 2016 was overstated;

that is, the count erroneously showed $7,000 of inventory on
hand.
2016 2017
Sales revenue $50,000 $40,000
Cost of goods sold: $ 7,000
↓
Beginning inventory $10,000 25,000
↓
Net purchases 20,000 $32,000
Cost of goods available for sale $30,000 10,000
↓
Ending inventory 7,000
↓
Cost of goods sold 23,000 ↓ 22,000
↓
Gross margin $27,000 $18,000 ↓
Operating expenses 10,000 10,000
↓
Net income $17,000 $ 8,000 ↓
LO3
Quiz Yourself
◆ Beginning inventory was $50,000. Purchases for the

period total $760,000. A physical count at the end of
the period revealed ending inventory of $62,500.
Compute cost of goods sold for the period.
Solution
Beginning inventory $ 50,000
……………………………….
Plus purchases ………………………………….. 760,000
Goods available for sale $810,000
………………………….
Less ending inventory - 62,500
…………………………….
Cost of goods sold $747,500
………………………………...
LO3
Quiz Yourself
◆ Davis Company uses a periodic inventory system.

Ending inventory for this period was understated by
$150,000. What will be the effect of this error on this
period’s net income? Next period’s net income?
LO3
Quiz Yourself
Solution
◆ For this period, ending inventory will be understated by
$150,000, which means cost of goods sold will be
overstated by $150,000.
◆ If cost of goods sold is overstated, then income will be
understated by $150,000 (ignoring taxes).
◆ Next period, the effect will be exactly the opposite.
Beginning inventory will be too low, which means cost of
goods sold will be understated by $150,000, and net
income will be overstated by $150,000.
LO4 Cost Formulas for Inventory
Cost Formulas for Inventory
◆ FIFO (first in, first out)

IFRS does not allow
the use of LIFO.
◆ LIFO (last in, first out)
◆ Weighted Average Cost
◆ Specific Identification
LO4
Cost Formulas for Inventory
Illustration
► Assume that the periodic system is adopted, consider
the September 2017 records of Nephi Company, which
sells one type of bicycle.
LO4
Specific Identification Cost Formula
◆ Each item is specifically identified.

◆ Usually used for large or expensive items.
Illustration
► Suppose that of the 28 bicycles sold by Nephi on
September 25, 8 came from the beginning inventory, 4
came from the September 3 purchase, and 16 came
from the September 18 purchase.
LO4
Illustration
► The cost of ending inventory is the total of the individual
costs of the bicycles still on hand at the end of the
month.
LO4
Illustration
► The cost of goods sold is the total of the costs of the
specific bicycles sold.
LO4
FIFO Cost Formula
◆ It is assumed that the oldest units are sold and the newest
units remain in inventory.
Illustration
LO4
FIFO Cost Formula
Illustration
LO4
Weighted Average Cost Formula
◆ With weighted average cost formula, a weighted average

cost must be computed for all the inventory available for
sale during the period.
Illustration
LO4
Illustration
Weighted Average Cost of Goods Sold: 28 units x $272.73 per unit=$7,636
(rounded)
Weighted Average Ending Inventory: 16 units x $272.73 per unit=$4,364 (rounded)
LO4
FIFO vs. Weighted Average Cost Formula
Comparison
► When prices are increasing, companies tend to prefer FIFO

because the performance looks better.
► From the perspective of financial position, FIFO measures

inventory value better because it approximates current cost.
LO4
Quiz Yourself
◆ Zielesch Company reports the following activity during

March related to its inventory of watches:
Mar 1 Beginning inventory consisted of 6 watches costing $40
. each.
5 Purchased 10 watches costing $ 45 each.
11 Purchased 7 watches costing $48 each.
22 Purchased 11 watches costing $50each.
27 Sold 27 watches for $150 each.
◆ Determine (a) the cost of goods sold for the month and (b)
the ending inventory balance for March 31 using
1. FIFO cost formula
2. Weighted average cost formula
LO4
Quiz Yourself
Solution
LO4
Quiz Yourself
Solution
1. FIFO cost formula
a. FIFO cost of goods sold
6 watches from beginning inventory,$40 each $ 240
10 watches purchased March 5, $45 each 450
Total cost of goods sold (27units) $ 1,226
b. FIFO ending inventory

7 watches purchased March 22, $50 each $ 350
LO4
Quiz Yourself
Solution
2. Weighted average cost formula
a. Weighted average cost of goods sold
27 units ⨉ $46.3529 per unit = $1,252 (rounded)

b. Weighted average ending inventory
7 units ⨉ $46.3529 per unit = $324 (rounded)
LO5 Valuing and Reporting Inventory at the Lower of Cost or Net Realizable Value
Inventory Valued at Net Realizable Value
Net Realizable Value

► The selling price of an item less reasonable selling
costs.
Lower of Cost or Net Realizable Value
► Compare the inventory cost to its net realizable value,
and report the lower of cost or net realizable value on
the balance sheet.
LO5
Inventory Valued at Net Realizable Value
Illustration
◆ An automobile dealer has a demonstrator car that
originally cost $18,000 and now can be sold for only
$16,000. A commission of $500 must be paid to sell the
car.

Allowance for Inventory Write-Down 2,500
To write down inventory to its net realizable value. a contra account
to Inventory
LO5
Quiz Yourself
◆ For each of the following, identify the appropriate inventory

value to be reported on the balance sheet by comparing
with historical cost with the net realizable value.
Solution
Item A—$31 Item B—$17
Item C—$22 Item D—$45
LO6 Assessing How Well Companies Manage Their Inventories
Evaluating the Level of Inventory
Inventory Turnover
► Provides a measure of how many times a company
turns over, or replenishes, its inventory during a year.
Cost of Goods Sold
Inventory Turnover =
Average Inventory
LO6
Number of Days’ Sales in Inventory

► Provides a measure of how many days’ worth of sales
does the company have in inventory.
Number of Days’ 365

Sales in Inventory = Inventory Turnover
LO6
Illustration
LO6
Number of Days’ Purchases in Accounts Payable
► Provides a measure of how many days’ worth of

inventory does the company have in accounts payable.
Number of Days’ Purchases = 365

in Accounts Payable Purchases / Average Accounts Payable
Illustration
LO6
Number of Days’ Purchases in Accounts Payable
Illustration
► Sears’ 103-day operating cycle for 2015.
LO6
Quiz Yourself
◆ Skiba Company reported the following information for

the year:
Ending inventory $3,000
Cost of goods sold 4,200
Beginning inventory 2,600
◆ Compute (1) inventory turnover and (2) number of

days’ sales in inventory.
LO6
Quiz Yourself
Solution
1. Inventory Turnover
$4,200/[($2,600 + $3,000)/2] = 1.50 times
2. Number of Days’ Sales in Inventory
365/1.50 = 243.33 days
LO7 LIFO Cost Formula
LIFO Cost Formula
◆ LIFO is the opposite of FIFO. With LIFO, the cost of the

most recent units purchased is transferred to cost of goods
sold.
Illustration
► Using the LIFO inventory cost flow assumption, the cost
of goods sold and ending inventory for Nephi are:
LO7
LIFO Cost Formula
Illustration
LO7
Comparison of the Three Cost Formulas
LO7
Conceptual Comparison
► LIFO gives a better reflection of cost of goods than
does FIFO because the most recent goods (“last in”),
with the most recent costs, are assumed to have been
sold.
► FIFO gives a better measure of inventory value
because, with FIFO, the “first in” units are sold and the
remaining units are the newest ones with the most
recent costs.
LO7
Financial Statement Impact Comparison
► As with Nephi, in times of rising inventory prices (the

most common situation in the majority of industries today),
cost of goods sold is highest with LIFO and lowest with
FIFO.
► Gross margin, net income, and ending inventory are

lowest with LIFO and highest with FIFO.
► The advantage of LIFO is the attractiveness of lower

income tax.
► LIFO significantly understates ending inventory and reports

lower profits when prices are rising.
LO7
Impact of the Cost Formula

► Comparison for Caterpillar in 2008:
Higher
Shorter
LO7
Quiz Yourself
◆ Zielesch Company reports the following activities

during March related to its inventory of watches:
Mar 1 Beginning inventory consisted of 6 watches costing $40 each.

.
5 Purchased 10 watches costing $ 45 each.
11 Purchased 7 watches costing $48 each.
22 Purchased 11 watches costing $50each.
27 Sold 27 watches for $150 each.
◆ Determine (a) the cost of goods sold for the month and
(b) the ending inventory balance for March 31 using
LIFO cost formula.
LO7
Quiz Yourself
Solution
a. LIFO cost of goods sold
9 watches purchased March 5, $45 each $ 405
Total cost of goods sold (27 units) $ 1,291
b. LIFO ending inventory

6 watches from beginning inventory, $40 each $ 240
Total ending inventory (7 units) $ 285
Complications of the Perpetual System with LIFO and Weighted
LO8 Average Cost
Perpetual System with LIFO and Weighted Average
Cost
◆ FIFO periodic and FIFO perpetual systems yield the same
numbers for cost of goods sold and ending inventory.
◆ Because no matter when sales occur, the “first in” units are
always the same ones.
◆ Computation of weighted average cost and LIFO under a
perpetual system is complicated
◆ The weighted average cost of units available for sale
changes every time a purchase is made, and the
identification of the “last in” units also changes with every
purchase.
LO8
Perpetual System with LIFO and Weighted Average Cost
Illustration
► These perpetual system complications are illustrated
below for Nephi.
LO8
LIFO Cost Formula
Illustration
► The identification of the “last in” units must be evaluated
at the time of each individual sale.
LO8
Illustration
► A new weighted average cost per unit must be
determined at the time each individual sale is made.
Methods of Estimating Inventories
LO9
The Gross Margin Method
◆ Used when a physical count of inventory is impossible or

impractical.
◆ Cost of goods sold and ending inventory are estimated
using available information:
► Beginning inventory
► Purchases
► Historical gross margin percentage
LO9
Illustration
► Assume the following data for Payson Brick Company:
LO9
Illustration
Dollars % of Sales
Net sales revenue $100,000 100%
Cost of goods sold:
Beginning inventory $15,000
Net purchases 65,000
Total cost of goods available for sale $80,000
Ending inventory ($80,000 − $60,000) 20,000 (3)
Cost of goods sold ($100,000 − $40,000) 60,000 (2) 60%
Gross margin ($100,000 × 0.40) $40,000 (1) 40%
Step 1: Gross margin is first determined by calculating 40% of sales

Step 2: Cost of goods sold is found by subtracting gross margin from sales
Step 3: The dollar amount of ending inventory is obtained by subtracting cost of goods
sold from total cost of goods available for sale.
LO9
The Retail Inventory Method
◆ Estimate the cost of ending inventory by

► Identifying the cost-to-retail percentage.
► Then multiplying this percentage by the retailing price of
ending inventory.
LO9
The Retail Inventory Method
Illustration
► Assume that Dyson Packard Company applies the retail
inventory system to estimate its ending inventory.
0.65
Step 1: Cost-to-retail-ratio = £65,000 ÷ £100,000 = 0.65
Step 2: Ending inventory at retail = £100,000 – £80,000 = £20,000

Step 3: Estimated cost of ending inventory = £20,000 ⨉ 0.65 = £13,000
LO9
Quiz Yourself
◆ Given the following information, estimate ending

inventory using the gross margin method, and the
retail inventory method, respectively.

Purchases year to date 186,000
Sales year-to-date 320,000
Historical gross margin percentage 35%
Cost-to-retail ratio 60%
LO9
Quiz Yourself
Solution
a. Gross margin method:
► Estimated cost of goods sold = $320,000 × 65% =
$208,000

Plus purchases 186,000
Goods available for sale at cost $243,000
Less cost of goods sold 208,000
Ending inventory (estimated) $ 35,000
LO9
Quiz Yourself
Solution
b. Retail inventory method:
► Goods available for sale at retail
= $243,000 ÷ 60% = $405,000
► Ending inventory at retail
= $405,000 – $320,000 = $85,000
► Ending inventory at cost
= $85,000 × 60% = $51,000

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CHAPTER

Inventory and the Cost of Sales

LO6 LO7 LO8 LO9

Activity: Buying/Making and Selling Inventory

Goods Being Shipped

Cost of Goods Available for Sale

Beginning Inventory Cost of Goods

The Cost Allocation Process

Perpetual vs. Periodic System

Perpetual Inventory System

b. Inventory 5,400 Purchases 5,400

Accounts Payable 5,400 Accounts Payable 5,400

c. Inventory 970 Freight In 970

Cash 970 Cash 970

d. Accounts Payable 300 Accounts Payable 300

Inventory 300 Purchase Returns 300

e. Accounts Payable 9,700 Accounts Payable 9,700

Inventory 194 Purchase Discounts 194

Cash 9,506 Cash 9,506

f. Accounts Payable 5,400 Accounts Payable 5,400

Cash 5,400 Cash 5,400

Sales (600 x $25) 15,000 Sales 15,000

► Under periodic system, Grantsville would not even know

Accounts Receivable 1,250 Accounts Receivable 1,250

Inventory (50 x $10) 500

(Ending) Inventory Cost of goods

Cost of Goods Sold 9,100

◆ For each of the following businesses, indicate whether

Taking a Physical Count of Inventory

Illustration-Perpetual Inventory System

Cost of Goods Sold 826

Illustration-Periodic Inventory System

Cost of Goods Sold 9,926

► Now suppose that ending inventory in 2016 was overstated;

◆ Beginning inventory was $50,000. Purchases for the

◆ Davis Company uses a periodic inventory system.

Cost Formulas for Inventory

◆ FIFO (first in, first out)

◆ Each item is specifically identified.

◆ With weighted average cost formula, a weighted average

► When prices are increasing, companies tend to prefer FIFO

► From the perspective of financial position, FIFO measures

◆ Zielesch Company reports the following activity during

b. FIFO ending inventory

a. Weighted average cost of goods sold

27 units ⨉ $46.3529 per unit = $1,252 (rounded)

Inventory Valued at Net Realizable Value

Net Realizable Value

Cost of Goods Sold 2,500

◆ For each of the following, identify the appropriate inventory

Evaluating the Level of Inventory

Number of Days’ Sales in Inventory

Number of Days’ 365

► Provides a measure of how many days’ worth of

Number of Days’ Purchases = 365

◆ Skiba Company reported the following information for

◆ Compute (1) inventory turnover and (2) number of

LIFO Cost Formula

◆ LIFO is the opposite of FIFO. With LIFO, the cost of the