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Inventories and the Cost

of Goods Sold
Chapter 8

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


The Flow of Inventory
Costs
BALANCE SHEET

Purchase costs (or


Asset
manufacturing Inventory
costs)
as goods
INCOME STATEMENT are sold

Revenue
Cost of goods sold
Gross profit
Expenses
Net income
8-2
The Flow of Inventory
Costs
In a perpetual inventory system, inventory
entries parallel the flow of costs.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Entry on Purchase Date
Inventory $$$$
Accounts Payable $$$$

Entry on Sale Date


Cost of Goods Sold $$$$
Inventory $$$$
8-3
Which Unit Did We Sell?
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.

8-4
Inventory Subsidiary
Ledger
AA separate
separate subsidiary
subsidiary account
account isis maintained
maintained
for
for each
each item
item in
in inventory.
inventory.

Ite m LL002 Primary supplier Electronic City


Description Laser Light Secondary supplierElectric Company
Location Storeroom 2 Inventory level: Min: 25 Max : 200
Purchased Sold Ba lance
Cost of
Unit Unit Goods Unit
Date Units Cost Total Units Cost Sold Units 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 ? ? ? ? ?
? ? ?

How can we determine the unit cost for the Sept. 10 sale?
8-5
Inventory Valuation Methods: A Summary
Costs Allocated to:
Valuation Cost of Goods
Method Sold Inventory Comments
Specific Actual cost of Actual cost of units Parallels physical flow
identification the units sold remaining Logical method when units
are unique
May be misleading for
identical units
Average cost Number of units Number of units on Assigns all units the same
sold times the hand times the average unit cost
average unit cost average unit cost Current costs are averaged
in with older costs
First-in, First-out Cost of earliest Cost of most Cost of goods sold is based
(FIFO) purchases on recently on older costs
hand prior to the purchased units Inventory valued at current
sale costs
May overstate income during
periods of rising prices; may
increase income taxes due
Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at
(LIFO) recently purchases recent prices
purchased units (assumed still in Inventory shown at old (and
inventory) perhaps out of date) costs
Most conservative method
during periods of rising
prices; often results in lower
income taxes

8-6
The Principle of
Consistency
Once a company has
adopted a particular
accounting method, it
should follow that
method consistently
rather than switch
methods from one
year to the next.

8-7
Taking a Physical
Inventory
The
The primary
primary reason
reason for
for taking
taking aa physical
physical
inventory
inventory is
is to
to adjust
adjust the
the perpetual
perpetual inventory
inventory
records
records for
for unrecorded
unrecorded shrinkage
shrinkage losses,
losses,
such
such as
as theft,
theft, spoilage,
spoilage, or
or breakage.
breakage.

8-8
LCM and Other Write-
Downs
of Inventory
Reduces
Reduces the the value
value
Obsolescence
Obsolescence of
of the
the inventory.
inventory.

Lower
Lower ofof Cost
Cost Adjust
Adjust inventory
inventory
or
or Market
Market value
value toto the
the lower
lower
(LCM)
(LCM) of
of historical
historical cost
cost or
or
current
current
replacement
replacement cost cost
(market).
(market).
8-9
Goods In Transit
A
A sale
sale should
should be
be recorded
recorded when
when title
title to
to
the
the merchandise
merchandise passes
passes to
to the
the buyer.
buyer.

F.O.B.
F.O.B. F.O.B.
F.O.B.
shipping
shipping destination
destination
point 
point title
title point 
point title
title
passes
passes to to passes
passes toto
buyer
buyer at
at the
the Year buyer
buyer at
at the
the
point
point of
of End point
point of
of
shipment.
shipment. destination.
destination.
8-10
Periodic Inventory
Systems
In a periodic inventory system, inventory
entries are as follows.

Note
Note that
that an
an entry
entry is
is not
not
made
made to to inventory.
inventory.
8-11
Periodic Inventory
Systems
In a periodic inventory system, inventory
entries are as follows.

8-12
Importance of an Accurate
Valuation of Inventory
Errors in Measuring Inventory
Beginning Inventory Ending Inventory
Effect on Income StatementOverstated Understated Overstated Understated
Goods Available for Sale + - NE NE
Cost of Goods Sold + - - +
Gross Profit - + + -
Net Income - + + -
Effect on Balance Sheet
Ending Inventory NE NE + -
Retained Earnings - + + -

An
An error
error in
in ending
ending inventory
inventory in
in aa year
year will
will result
result in
in the
the
same
same error
error in
in the
the beginning
beginning inventory
inventory of of the
the next
next
year.
year.
8-13
The Gross Profit Method
1.
1. Determine
Determine cost
cost of
of goods
goods
available
available for
for sale.
sale.
2.
2. Estimate
Estimate cost
cost of
of goods
goods
sold
sold by
by multiplying
multiplying the
the
net
net sales
sales by
by the
the cost
cost
ratio.
ratio.
3.
3. Deduct
Deduct cost
cost of
of goods
goods sold
sold
from
from cost
cost of
of goods
goods
available
available for
for sale
sale to
to
determine
determine ending
ending
inventory.
inventory.

8-14
The Retail Method
The
The retail
retail method
method of
of estimating
estimating inventory
inventory
requires
requires that
that management
management determine
determine thethe
value
value of
of ending
ending inventory
inventory at
at retail
retail prices.
prices.
In
In March
March of
of 2009,
2009, Matrix
Matrix Company’s
Company’s inventory
inventory waswas
destroyed
destroyed by
by fire.
fire. At
At the
the time
time of
of the
the fire,
fire, Matrix’s
Matrix’s
management
management collected
collected the
the following
following information:
information:
Information for Matrix Company
The Retail Method
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

8-15
End of Chapter 8

8-16