Inventories and Cost of Sales

Chapter 5

Wild & Shaw

Financial and Managerial Accounting
9th Edition

Copyright ©2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Chapter 5 Learning Objectives
CONCEPTUAL
C1 Identify the items and costs of merchandise inventory.

ANALYTICAL
A1 Analyze the effects of inventory methods for both financial and tax reporting.
A2 Analyze the effects of inventory errors on current and future financial statements.
A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

PROCEDURAL
P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO,
and weighted average.
P2 Compute the lower of cost or market amount of inventory.
P3 Appendix 5A—Compute inventory in a periodic system using the methods of specific identification,
FIFO, LIFO, and weighted average.
P4 Appendix 5B—Apply both the retail inventory and gross profit methods to estimate inventory.

© McGraw-Hill Education 5-2

 Learning Objective C1

Identify the items and costs of

merchandise inventory.

© McGraw-Hill Education 5-3

 Determining Inventory Items
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment

© McGraw-Hill Education 5-4

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Goods in Transit
• FOB shipping point – goods included in buyer’s
inventory when shipped.
• FOB destination – goods included in buyer’s
inventory after arrival at destination.
Exhibit
5.1

© McGraw-Hill Education 5-5

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Goods on Consignment
• Consignor: owner of goods.
• Consignee: sells goods for the owner.
• Merchandise is included in the inventory of the
consignor.
• Consignee never reports consigned goods in
inventory.

© McGraw-Hill Education 5-6

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Goods Damaged or Obsolete
• Damaged or obsolete goods are not reported in
inventory if they cannot be sold.
• Damaged or obsolete goods which can be sold
are included in inventory at net realizable value.
• Net realizable value = sales price minus selling
costs.
• Loss is recorded when damage or obsolescence
occurs.

© McGraw-Hill Education 5-7

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Determining Inventory Costs
• Include all expenditures necessary to bring
an item to a salable condition and location.
• Inventory cost = Invoice cost - discounts +
other costs
• Other costs include:
• Shipping
• Storage
• Insurance
• Import duties
© McGraw-Hill Education 5-8
Learning Objective C1: Identify the items and costs of merchandise inventory.
 Internal Controls and Taking a Physical Count
 Most companies take a  Physical count is used to
physical count of adjust the inventory account
balance to the actual
inventory at least once inventory available.
each year.

Good internal controls over the inventory count include:

1. Prenumbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counters confirm existence, amount, and
condition of inventory.
4. Second count is taken by a different counter.
5. Manager confirms all items counted only once.
© McGraw-Hill Education 5-9
Learning Objective C1: Identify the items and costs of merchandise inventory.
 Inventory Costing Methods
Four methods are used to assign costs to
inventory and to cost of goods sold:

1. Specific identification
2. First-in, First-out (FIFO)
3. Last-in, First-out (LIFO)
4. Weighted average

© McGraw-Hill Education 5-10

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Inventory Cost Flow Methods
Exhibit
5.2

© McGraw-Hill Education 5-11

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Cost Flow of Inventory

© McGraw-Hill Education 5-12

Learning Objective C1: Identify the items and costs of merchandise inventory.
 Learning Objective P1

Compute inventory in a
perpetual system using the
methods of specific
identification, FIFO, LIFO, and
weighted average.

© McGraw-Hill Education 5-13

 Inventory Costing under
a Perpetual System

Balance Income
Inventory Statement:
Sheet:
Ending affects Cost of
Inventory Goods Sold

Physical flow does not

need to follow cost
flow.

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-14
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration:
Perpetual System
Exhibit
5.3

Here is information about the mountain bike inventory of Trekking

for the month of August.

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 6-15
identification, FIFO, LIFO, and weighted average.
 Specific Identification: Exhibit

Perpetual 5.4

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-16
identification, FIFO, LIFO, and weighted average.
 First-In, First-Out (FIFO):
Definition Perpetual
Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-17
identification, FIFO, LIFO, and weighted average.
 First-In, First-Out (FIFO):
Exhibit
Perpetual 5.5

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-18
identification, FIFO, LIFO, and weighted average.
 Last-In, First-Out (LIFO):
Definition Perpetual
Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-19
identification, FIFO, LIFO, and weighted average.
 Last-In, First-Out (LIFO):
Exhibit
Perpetual 5.6

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-20
identification, FIFO, LIFO, and weighted average.
 Weighted Average:
Perpetual
When a unit is sold, the average cost of each unit
in inventory is assigned to cost of goods sold.

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-21
identification, FIFO, LIFO, and weighted average.
 Weighted Average: Perpetual Part 1

On August 14, 20 bikes are sold. To determine the cost of the

units sold, we first need to compute the weighted average cost
per unit of items in inventory.
Cost of goods available for sale $ 2,500
Units available at time of sale ÷ 25
Weighted average cost per unit $ 100

The cost of goods sold for the August 14 sale is $2,000. After
this sale, there are five $100 units in inventory totaling $500.
Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-22
identification, FIFO, LIFO, and weighted average.
 Weighted Average: Perpetual Part 2

August 17:
Cost of goods available for sale $ 2,800
Units available at time of sale 5 + 20 ÷ 25
Weighted average cost per unit $ 112

After the August 14 sale, there are 5 units in inventory totaling $500.
On August 17, 20 units are purchased for $2,300.
($2,300 + 500) / 25 = $2,800 / 25 = $112 per unit.
Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-23
identification, FIFO, LIFO, and weighted average.
 Weighted Average: Perpetual Part 3

August 28:
Cost of goods available for sale $ 3,990
Units available at time of sale 5+20+10
Weighted average cost per unit $
÷ 35
114

After
Afterthe
theAugust
August28 28purchase,
purchase,there
thereare
are(5
(5++20
20++10)
10)==35
35units
unitsin
in
inventory
inventorytotaling
totaling($2,800
($2,800++1,190)
1,190)==$3,990.
$3,990.
$3,900
$3,900//35
35==$114
$114per
perunit.
unit.
Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-24
identification, FIFO, LIFO, and weighted average.
 Weighted Average: Perpetual Part 4
Exhib
it 5.7

Ending inventory is
Cost
Cost of
of goods
goods sold
sold for
for composed of 12 units @
August
August 30
30 sale
sale is
is == $2,622
$2,622 an average cost of $114
each or $1,368.
Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 6-25
identification, FIFO, LIFO, and weighted average.
 Weighted Average: Perpetual Part 5
Exhibit
5.7

Learning Objective P1: Compute inventory in a perpetual system using the methods of specific © McGraw-Hill Education 5-26
identification, FIFO, LIFO, and weighted average.
 Learning Objective A1

Analyze the effects of

inventory methods for both
financial and tax reporting.

© McGraw-Hill Education 5-27

 Financial Statement Effects
of Costing Methods
First-In, Last-In, Weighted
First-Out First-Out Average

Cost of goods sold

Ending inventory on income
Smooths out
approximates statement
price changes.
current cost. approximates its
current costs.

© McGraw-Hill Education 5-28

Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting.
 Financial Statement Effects of
Inventory Costing Methods Exhibit
5.8

Because
Because prices
prices change,
change, inventory
inventory methods
methods nearly
nearly always
always assign
assign
different
different cost
cost amounts.
amounts.

© McGraw-Hill Education 5-29

Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting.
 Tax Effects of Costing Methods
The Internal Revenue Service (IRS) requires that
when LIFO is used for tax reporting, it must
also be used for financial reporting. This is
called the LIFO conformity rule.

© McGraw-Hill Education 5-30

Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting.
 Learning Objective P2

Compute the lower of cost or

market amount of inventory.

© McGraw-Hill Education 5-31

 Lower of Cost or Market (1 of 2)
Inventory must be reported at market
value when market is lower than cost.

Can be applied three ways:

Defined as current (1) separately to each
individual item.
replacement cost
(2) to major categories of
(not sales price).
assets.
(3) to the whole inventory.

© McGraw-Hill Education 5-32

Learning Objective P2: Compute the lower of cost or market amount of inventory.
 Lower of Cost or Market (2 of 2)
A motor sports retailer has the following Exhibit
items in inventory: 5.9

Journal entry to write down inventory follows:

Learning Objective P2: Compute the lower of cost or market amount of © McGraw-Hill Education 5-33
inventory
 Learning Objective A2

Analyze the effects of

inventory errors on current
and future financial
statements.

© McGraw-Hill Education 5-34

 Income Statement Effects of
Inventory Errors

Exhibit
s 5.10
and
5.11

© McGraw-Hill Education 6-35

Learning Objective A2: Analyze the effects of inventory errors on current and future financial statements.
 Financial Statement Effects of
Inventory Errors
Balance Sheet Effects Exhibit
5.12

© McGraw-Hill Education 5-36

Learning Objective A2: Analyze the effects of inventory errors on current and future financial statements.
 Learning Objective A3

Assess inventory management

using both inventory turnover
and days’ sales in inventory.

© McGraw-Hill Education 5-37

 Inventory Turnover
Shows how many times a company turns over its inventory
during a period. Indicator of how well management is
controlling the amount of inventory available.
Exhib
Inventory Cost of goods sold it

turnover = Average inventory

5.13

Average (Beg. Inv. + End Inv.)

=
Inventory ÷2
Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales in inventory. © McGraw-Hill Education 5-38
 Days’ Sales in Inventory
Reveals how much inventory is available in
terms of the number of days’ sales.
Exhib
it
5.14

Days‘ sales in Ending inventory

inventory = × 365
Cost of goods sold

Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales in inventory. © McGraw-Hill Education 5-39
 Analysis of Inventory Management
Merchandisers plan and control inventory
purchases and sales.
Costco and Walmart’s inventory turnover and
days’ sales in inventory are shown below:
Exhibit
5.15

Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales in inventory. © McGraw-Hill Education 6-40
 Learning Objective P3
Appendix 5A:
Compute inventory in a
periodic system using the
methods of specific
identification, FIFO, LIFO, and
weighted average.
© McGraw-Hill Education 5-41
 Inventory Costing under
a Periodic System

Balance Income
Inventory Statement:
Sheet:
affects Cost of
Ending Goods Sold
Inventory
Physical flow does
not need to follow
cost flow.

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-42
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration
Periodic System Exhibit
5A.1

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-43
identification, FIFO, LIFO, and weighted average.
Inventory Costing Illustration Periodic System
Specification Identification
Exhibit
5A.2

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-44
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration
Periodic System - FIFO
Exhibit
5A.3

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-45
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration
Periodic System - LIFO
Exhibit
5A.4

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-46
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration
Periodic System – Weighted Average
When
When aa unit
unit isis sold,
sold, the
the average
average cost
cost of
of each
each
unit
unit in
in inventory
inventory isis assigned
assigned to
to cost
cost of
of goods
goods
sold.
sold.

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-47
identification, FIFO, LIFO, and weighted average.
 Inventory Costing Illustration
Exhibit
Periodic System – Weighted 5A.5

Average: Cost per Unit

Learning Objective P3: Compute inventory in a periodic system using the methods of specific © McGraw-Hill Education 5-48
identification, FIFO, LIFO, and weighted average.
 Learning Objective P4
Appendix 5B:
Apply both the retail
inventory and gross profit
methods to estimate inventory.

© McGraw-Hill Education 5-49

 Exhibits
Inventory Estimation Methods 5B.1 &
5B3
Inventory sometimes requires estimation for interim statements
or if some casualty such as fire or flood makes taking a
physical count impossible.
Retail Inventory Method Gross Profit Method

© McGraw-Hill Education 5-50

Learning Objective P4: Apply both the retail inventory and gross profit methods to estimate inventory.
End of Chapter 5

© McGraw-Hill Education 5-51