Chapter 6

Inventories and

Cost of Goods Sold

Gross Profit andCost of Goods Sold

• An initial step in assessing profitability is gross profit (profit margin or gross margin), which is the difference between sales revenues and the costs of the goods sold.

• Products being held for resale are reported as inventory, a current asset.– When the goods are sold, the costs of the inventory

become an expense, Cost of Goods Sold. This expense is deducted from Net Sales to determine Gross Profit.

The Basic Concept ofInventory Accounting

• The key to calculating cost of goods sold is accounting for the remaining inventory at the end of the year.

• Cost valuation - process of assigning specific historical costs to items counted in the physical inventory– Multiply the number of items in ending

inventory times the cost of each item.

Perpetual and PeriodicInventory Systems

• Two main systems for keeping merchandise inventory records:– Perpetual inventory system - a system that keeps a

running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis

– Periodic inventory system - a system in which the cost of good sold is computed periodically by relying solely on physical counts without keeping day-to-day records of units sold or on hand

Perpetual and PeriodicInventory Systems

• A perpetual inventory system helps managers control inventory levels and prepare interim financial statements.– The inventory amount can be found at any given

point in time.

• Inventory items must be counted at least once a year to ensure correct valuation.– Physical count - the process of counting all the items

in inventory at a moment in time

Perpetual and PeriodicInventory Systems

• In a perpetual system, the journal entries are:

When inventory is purchased:

Merchandise inventory xxx

Accounts payable (or Cash) xxx

When inventory is sold:

Accounts receivable (or Cash) xxx

Sales revenue xxx

Cost of goods sold xxx

Merchandise inventory xxx

Perpetual and PeriodicInventory Systems

• In a periodic system, no day-to-day inventory records are maintained.

• The physical count allows management to delete damaged or obsolete items and thus helps to reveal inventory shrinkage - inventory reductions from theft, breakage, or losses of inventory.

Perpetual and PeriodicInventory Systems

• Under the periodic system, calculations for cost of goods sold start with cost of goods available for sale, which is the sum of the beginning inventory plus current year purchases.

• Under the perpetual system, cost of goods sold is kept on a day-to-day basis.

Perpetual and PeriodicInventory Systems

• Both methods produce the same cost of goods sold figure.– The perpetual system is more timely, but it is

more costly to administer.– The perpetual system is less costly to

administer because there is no day-to-day processing regarding inventory costs or cost of goods sold.

Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems

• In the perpetual system, purchases of merchandise directly increase the Inventory account, and purchase returns and allowances and sales directly decrease the Inventory account.

• In the periodic system, purchases of merchandise increase the Purchases account, and purchase returns and allowances are placed in separate accounts that are deducted from Purchases.– Sales of merchandise have no effect on the Purchases

account.

Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems

• Under the perpetual system, inventory amounts are updated each time an inventory transaction is processed.

• Under a periodic system, the Inventory account does not change until the end of the accounting period.– At that time, a physical inventory is taken to

determine the amount of inventory on hand, and an entry is made to adjust the Inventory account to that amount.

Principal InventoryValuation Methods

• Four inventory valuation systems have been generally accepted.– Specific identification– First in, first out (FIFO)– Last in, first out (LIFO)– Weighted average

Principal InventoryValuation Methods

• If unit prices and costs did not change, all four inventory valuation methods would show identical results.

• Because prices change, cost of goods sold (income measurement) and inventories (asset measurement) are affected.– The choice of the inventory valuation method can

significantly affect the amount reported as net income and ending inventory.

FIFO• FIFO (first in, first out) method - assigns the cost

of the earliest acquired units to cost of goods sold– This might not be the actual physical flow of goods

within the company.– Under FIFO, the oldest units are deemed to be sold,

regardless of which units are actually given to the customer.

– The costs of the newer units in stock are included in ending inventory.

FIFO

• FIFO includes the most recent costs in ending inventory, so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date.

• Also, in periods when prices are rising, FIFO leads to higher net income because the costs of the older, lower costing items are included in cost of goods sold.

LIFO

• LIFO (last in, first out) method - assigns the most recent costs to cost of goods sold– This might not be the actual physical flow of

goods within the company.– Under LIFO, the newest units are deemed to be

sold, regardless of which units are actually given to the customer.

– The costs of the older units in stock are included in ending inventory.

LIFO

• LIFO uses the oldest costs to value ending inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date.

• In periods when prices are rising, LIFO yields lower net income because the higher costs of more recent purchases are put into cost of goods sold first.

LIFO

• Because LIFO results in reduced net income, it also results in lower income taxes. – The Internal Revenue Code requires that if a

company uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income.

– The result is lower income taxes and lower reported earnings figures to investors.

LIFO• If LIFO is such a good deal, why

do some companies still use FIFO?

• For several reasons:– The costs of changing methods can be significant.– Management may be reluctant to decrease earnings

and possibly salaries and bonuses.– Management might fear that lower income would

hurt in loan negotiations with banks.– Lower earnings will often lower stock prices.