McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventories and the Cost of Inventories and the Cost of Goods SoldGoods Soldotaleem.blogspot.comotaleem.blogspot.comfor more presentation(follow me)for more presentation(follow me)

Chapter 8

8-2

INCOME STATEMENT

Revenue Cost of goods sold Gross profit Expenses Net income

as goods are sold

BALANCE SHEET

Asset Inventory

Purchase costs (or manufacturing

costs)

The Flow of Inventory The Flow of Inventory CostsCosts

8-3

GENERAL JOURNAL

Date Account Titles and ExplanationPR Debit Credit

Entry on Purchase DateInventory $$$$

Accounts Payable $$$$

Entry on Sale DateCost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory entries parallel the flow of costs.

The Flow of Inventory The Flow of Inventory CostsCosts

8-4

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.

Which Unit Did We Sell? Which Unit Did We Sell?

8-5

Inventory Subsidiary Inventory Subsidiary LedgerLedger

A separate subsidiary account is maintained for each item in inventory.

How can we determine the unit cost for the Sept. 10 sale?

Item LL002 Primary supplier Electronic CityDescription Laser Light Secondary supplier Electric CompanyLocation Storeroom 2 Inventory level: Min: 25 Max: 200

Purchased Sold Balance

Date UnitsUnit Cost Total Units

Unit Cost

Cost of Goods Sold Units

Unit 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 ? ? ? ? ?

? ? ?

8-6

Inventory Valuation Methods: A SummaryCosts Allocated to:

Valuation Method

Cost of Goods Sold Inventory Comments

Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units

are uniqueMay be misleading for identical units

Average cost Number of units sold times the

Number of units on hand times the

Assigns all units the same average unit cost

average unit cost average unit cost Current costs are averaged in with older costs

First-in, First-out (FIFO)

Cost of earliest purchases on

Cost of most recently

Cost of goods sold is based on older costs

hand prior to the sale

purchased units Inventory valued at current costsMay overstate income during periods of rising prices; may increase income taxes due

Last-in, First-out (LIFO)

Cost of most recently

Cost of earliest purchases

Cost of goods sold shown at recent prices

purchased units (assumed still in inventory)

Inventory shown at old (and perhaps out of date) costsMost conservative method during periods of rising prices; often results in lower income taxes

8-7

Once a company has adopted a particular

accounting method, it should follow that

method consistentlyrather than switch methods from one year to the next.

The Principle of The Principle of ConsistencyConsistency

8-8

The primary reason for taking a physical inventory is to adjust the perpetual inventory

records for unrecorded shrinkage losses, such as theft, spoilage, or breakage.

Taking a Physical Taking a Physical InventoryInventory

8-9

Reduces the value of the inventory.Obsolescence

Adjust inventory value to the lower

of historical cost or current

replacement cost (market).

Lower of Cost or Market

(LCM)

LCM and Other Write-LCM and Other Write-DownsDownsof Inventoryof Inventory

8-10

Year End

A sale should be recorded when title to the merchandise passes to the buyer.

F.O.B. shipping

point title passes to

buyer at the point of

shipment.

F.O.B. F.O.B. destination destination pointpoint title passes to

buyer at the point of

destination.

Goods In TransitGoods In Transit

8-11

In a periodic inventory system, inventory entries are as follows.

Note that an entry is not made to inventory.

Periodic Inventory Periodic Inventory SystemsSystems

8-12

In a periodic inventory system, inventory entries are as follows.

Periodic Inventory Periodic Inventory SystemsSystems

8-13

Errors in Measuring InventoryBeginning Inventory Ending Inventory

Effect on Income Statement Overstated Understated Overstated UnderstatedGoods Available for Sale + - NE NECost of Goods Sold + - - +Gross Profit - + + -Net Income - + + -Effect on Balance SheetEnding Inventory NE NE + -Retained Earnings - + + -

An error in ending inventory in a year will result in the same error in the beginning inventory of the next

year.

Importance of an Accurate Importance of an Accurate Valuation of InventoryValuation of Inventory

8-14

The Gross Profit MethodThe Gross Profit Method1. Determine cost of

goods available for sale.

2. Estimate cost of goods sold by multiplying the net sales by the cost ratio.

3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

8-15

The Retail MethodThe Retail MethodThe retail method of estimating inventory requires that management determine the value of ending inventory at retail prices.

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

Information for Matrix CompanyThe Retail Method

In March of 2009, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s management collected the following information:

8-16

End of Chapter 8End of Chapter 8