Inventories and
Cost of Goods Sold

CHAPTER 
7
Learning Objectives
After studying this chapter, you should be able to
•	Link inventory valuation to gross profit
•	Use both perpetual and periodic inventory systems
•	Calculate the cost of merchandise acquired
•	Compute income and inventory values using the four principal inventory valuation methods
•	Calculate the impact on net income of LIFO liquidations
•	Use the lower-of-cost-or-market method to value inventories
Learning Objectives
After studying this chapter, you should be able to
•	Show the effects of inventory errors on financial statements
•	Evaluate the gross profit percentage and inventory turnover
Gross Profit and Cost of Goods Sold
•	Companies report products being held prior to sale as inventory—a current asset on the balance sheet
•	When the products are sold, the cost of the inventory becomes Cost of Goods Sold in the income statement
•	Net Sales less Cost of Goods Sold equals Gross Profit
•	Gross Profit less additional expenses equals Net Income
Gross Profit and Cost of Goods Sold
Perpetual and Periodic 
Inventory Systems
•	There are two main systems for keeping inventory records:
–	Perpetual system
–	Periodic system
•	The perpetual inventory system keeps a continuous record of inventories and cost of goods sold
•	The periodic inventory system computes cost of goods sold and an updated inventory balance only at the end of the accounting period
Perpetual Inventory System
•	In the perpetual inventory system, the journal entries are:
–	When inventory is purchased:

–	When inventory is sold:
Periodic Inventory System
•	Under the periodic system, the calculation of cost of goods sold is delayed until there is a physical count:
Physical Inventory
•	Inventory control procedures require a physical count of items held in inventory at least annually in both periodic and perpetual inventory systems
•	Firms often choose fiscal accounting periods so that the year ends when inventories are low
•	External auditors usually observe the client’s physical count and confirm its accuracy
Cost of Merchandise Acquired
•	The cost of merchandise includes the invoice price plus the directly identifiable inbound transportation charges less any offsetting discounts
•	The costs of purchasing and receiving are period costs and are charged on the income statement as they occur
Transportation Charges
•	When the seller bears the transportation cost, the sales invoice reads free onboard or F.O.B. destination
•	When the buyer bears the transportation cost, it reads F.O.B. shipping point
•	In practice, accountants frequently use a separate transportation cost account, Freight-in
•	Freight-in appears in the purchases section of an income statement as an additional cost of the goods acquired during the period
Returns, Allowances, and Discounts
•	Using the periodic inventory system, suppose a company’s gross purchases are $960,000 and purchase returns and allowances are $75,000.  The summary journal entries are:
Returns, Allowances, and Discounts
•	Suppose also that the company takes cash discounts of $5,000 on payment of the remaining $960,000 - $75,000 = $885,000 of payables.  The summary journal entry is:

•	To calculate cost of goods sold, Cash Discounts on Purchases and Purchase Returns and Allowances are subtracted from Purchases
Detailed Gross Profit Calculation
($ in thousands)
Principal Inventory Valuation Methods
•	In both systems, we must determine the costs of individual items by some inventory valuation method.
•	Four principal inventory valuation methods are generally accepted:
–	Specific identification
–	First-in, first-out (FIF0)
–	Last-in, first out (LIFO)
–	Weighted-average
Specific Identification
•	The specific identification method concentrates on physically linking the particular items sold with the cost of goods sold that is reported
•	This method is relatively easy to use for expensive low-volume merchandise
•	The use of bar cods and scanning equipment makes specific identification economically feasible for many companies
FIFO
•	FIFO assigns the cost of the earliest acquired units to cost of goods sold
•	The costs of the newer units is assigned to the units in ending inventory
•	FIFO provides inventory valuations that closely approximate the actual market value of the inventory at the balance sheet date
•	In periods of rising prices, FIFO leads to higher net income
LIFO
•	LIFO assigns the most recent cost to cost of goods sold
•	LIFO provides an income statement perspective in that net income measured using LIFO combines current sales prices and current acquisition costs
•	In a period of rising prices and constant or growing inventories, LIFO yields lower net income
•	The Internal Revenue Cods requires companies that use LIFO for tax purposes to also use it for financial reporting purposes
Weighted Average
•	The weighted-average method computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale
•	The weighted-average method produces gross profit somewhere between that obtained under FIFO and LIFO
Inventory Valuation Methods Example
•	Assume a vendor of soft drinks starts out the week with no inventory
•	He buys and sells cola as follows:
–	Buys one can on Monday for 30 cents
–	Buys one can on Tuesday for 40 cents
–	Buys one can on Wednesday for 56 cents
–	Sells one can on Thursday for 90 cents
•	The next slide shows the vendor’s cost of goods sold and ending inventory under the four methods
Inventory Valuation Methods Example
Cost Flow Assumptions
•	Companies may choose any of the four methods to record cost of goods sold
•	Three out of the four methods are not linked to the physical flow of merchandise
•	Accountants often refer to inventory methods as cost flow assumptions
Inventory Cost Relationships
•	The difference in the four methods centers on how inventory costs are allocated between inventory and cost of sales
•	The difference between FIFO and LIFO is:
The Consistency Convention
•	Companies can choose any inventory cost flow assumption, but they must be consistent over time with the method they choose
•	Consistency is defined as “conformity from period to period with unchanging policies and procedures”
•	A change in market conditions may justify a change in inventory method
•	The firm must note the change in its financial statements
Characteristics and 
Consequences of LIFO
•	LIFO 
–	Is widely used in the United States
–	Has strong tax benefits for companies
–	Has some unusual features
•	Few companies outside the U. S. use LIFO
Holding Gains and Inventory Profits
•	LIFO matches the most recent acquisition cost with sales revenues
•	LIFO cost of goods sold typically offers a close approximation to the replacement cost
•	Reported net income rarely contains significant holding gains 
•	FIFO reports a profit which includes an economic profit plus the holding gain because the value of the inventory rises over time

LIFO Layers
•	A LIFO layer is an addition to inventory at an identifiable cost level
•	As a company grows, the LIFO layers pile on top of one another over the years
•	LIFO inventory values may be far below market value or current replacement value of the inventory
•	While LIFO better presents the economic reality on the income statement, FIFO provides more current valuations on the balance sheet
LIFO Inventory Liquidations
•	A LIFO liquidation occurs when the physical amount of inventory decreases, and the cost of goods sold consists of old, low inventory acquisition costs associated with old LIFO layers
•	A LIFO liquidation means that the current year’s income includes the cumulative inventory profit from years of increasing prices

LIFO Inventory Liquidations
•	The difference between a company’s LIFO inventory level and what it would be under FIFO is called a LIFO reserve
•	Most companies that use LIFO explicitly measure and report their LIFO reserve on the balance sheet itself or in the footnotes
Lower-of-Cost-or-Market Method
•	The lower-of-cost-or-market method (LCM) requires a comparison of the current market price of inventory with historical cost derived under one of the four primary methods used
•	The lower of the two amounts is reported as the inventory value
Role of Replacement Cost
•	Market price is generally considered to be the replacement cost of the inventory item—what it would cost to buy the inventory item today
•	A write-down reduces the recorded historical cost of an item in response to a decline in value
•	The required journal entry for a write-down is:
Effects of Inventory Errors
•	An undiscovered inventory error usually affects two reporting periods
•	The error will cause misstated amounts in the period in which the error occurred, but the effects will then be counterbalanced by identical offsetting amounts in the following period
•	If ending inventory is understated, retained earnings in understated
•	If ending inventory is overstated, retained earnings is overstated
Cutoff Errors and 
Inventory Valuation
•	Cutoff errors are failures to record transactions in the correct time period
•	Legal transfer of ownership controls the recording of purchases and sales near the year-end
•	The pressure for profits may cause managers to 
–	Delay the recording of purchases 
–	Include sales orders in revenues
The Importance of Gross Profits
•	Management and investors are interested in gross profit and how it changes over time
•	Gross profit is often expressed as a percentage of sales

•	Wholesalers have smaller gross profit percentages than retailers
•	R&D is treated as a period cost and not a product cost; thus, pharmaceutical companies have relatively high gross profit margins
Estimating Intraperiod Gross Profit 
and Inventory
•	The gross profit percentage can be used to estimate ending inventory balances for monthly or quarterly reports
•	Suppose a Home Depot Store has quarterly sales of $10 million and usually has a gross profit percentage of 30%.  Cost of goods sold can be estimated as:
Estimating Intraperiod Gross Profit 
and Inventory
•	Also assume the beginning inventory is $5 million and purchases are $7.1 million.  Ending inventory can be estimated as:
Gross Profit Percentage 
and Turnover
•	Inventory turnover relates sales levels to inventory levels
•	Inventory turnover in the previous Home Depot example would be:
Gross Profit Percentage 
and Turnover
•	Industries with higher gross profit percentages tend to have lower inventory turnover
•	Example: lower turnover for jewelers and drug manufactures means that they need a higher gross profit margin to cover the high costs of selling or research
•	Inventory turnover is especially effective in assessing companies in the same industry
–	Higher turnover is associated with greater efficiency
Gross Profit Percentages and 
Accuracy of Records
•	The gross profit percentage can be used to prove the accuracy of the accounting records
•	An unusually low percentage may mean the company has tried to avoid taxes by failing to record all sales
•	Some other factors that may cause a decline in the percentage are
–	Price wars that reduce selling prices
–	Shifting of the product mix sold
–	Increase in shoplifting or embezzlement
Internal Control of Inventories
•	Inventory shrinkage can result from customer shoplifting or employee embezzlement
•	The best deterrent for shoplifting is an alert employee at the point of sale
•	Retail stores also use:
–	Sensitized tags on merchandise
–	Surveillance cameras
Shrinkage in 
Perpetual Inventory Systems
•	Shrinkage is the difference between the cost of inventory from a physical count and the inventory balance in the general ledger
•	The journal entries to record shrinkage under a perpetual inventory system would be:
Shrinkage in 
Periodic Inventory Systems
•	A periodic inventory system has no running balance in the inventory account
•	Cost of goods sold automatically includes inventory shrinkage by virtue of the system
•	Shrinkage is much more difficult to isolate in the periodic system