CHAPTER 1

Inventories
Preview
Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials

 Work in Process

 Finished Goods

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet.
 Why accounting for inventories is crucial ?

 they take substantial investment of money

 the frequency of transactions involving
inventory are high
 they are principal source of revenue for
trading firms
 Cost of inventories sold is the largest
deduction from revenue
 Inventory Systems

Periodic Perpetual
The inventory value and CGS are determined Continuous record of both the physical flow and
only at important point in time . the cost of inventories and CGS.
Only revenue is recorded at time of sale Both revenue and CGS are recorded

Purchase & purchase related accounts are used No purchase and purchase related accounts

Physical inventory is undertaken to Physical inventory should be undertaken to test

determine Ending Inventory cost accuracy, to discover any shortage or overage
makes preparation of interim f/sts more costly Facilitates the preparation of interim f/sts
unless inventory estimation technique is used.
Weaker for internal control Stronger for internal control

More appropriate for low unit cost items For high unit cost items (not economical for low
unit cost items)
Inventory Systems…
Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
Determining Inventory Quantities

Taking a Physical Inventory

Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.
Determining Inventory Quantities

Determining Ownership of Goods

Goods in Transit
 Purchased goods not yet received.
 Sold goods not yet delivered.

Goods in transit should be included in the inventory of the

company that has legal title to the goods. Legal title is
determined by the terms of sale.
Determining Inventory Quantities

Goods in Transit

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.
Determining Inventory Quantities

Question
Goods in transit should be included in the inventory of the
buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

Determining Inventory Quantities

Determining Ownership of Goods

Consigned Goods
 Goods held for sale by one party.
 Ownership of the goods is retained by another
party.
Inventory Costing

Unit costs can be applied to quantities on hand using

the following costing methods:

 Specific Identification

 First-in, first-out (FIFO)

Cost Flow
 Last-in, first-out (LIFO)
Assumptions
 Average-cost
Inventory Costing

Illustration: Assume that A-TV Company purchases three

identical 50-inch TVs on different dates at costs of $700, $750,
and $800. During the year A-TV sold two sets at $1,200
each. These facts are summarized below.
Inventory Costing

Specific Identification
If A-TV sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Inventory Costing

Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of
the ending inventory.

 Practice is relatively rare.

 Gives the accurate cost information.

 Consistent with the physical flow of goods

 It is costly and requires tedious recordkeeping

 Income manipulation is possible

 Inventory Costing

Cost Flow
Assumptions
do not need to match the

physical movement of
goods

Use of cost flow methods in

major U.S. companies
 Inventory Costing

Illustration: Data for Houston Electronics’ Astro

condensers.

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

Inventory Costing

First-In-First-Out (FIFO)
 Earliest goods purchased are first to be sold.

 Often parallels actual physical flow of merchandise.

 Generally good business practice to sell oldest units

first.

 FIFO best approximates the current replacement value

of ending inventory in the balance sheet

 For income determination, earlier costs are matched

with current revenue resulting poor matching in the
income statement.
Inventory Costing

First-In-First-Out (FIFO)
Inventory Costing

First-In-First-Out (FIFO)
Inventory Costing

Last-In-First-Out (FIFO)
 Latest goods purchased are first to be sold.

 Seldom coincides with actual physical flow of

merchandise.

 match the most recent costs against the current

revenue

 The oldest purchase costs are assigned to inventory,

understated/Overstated in terms of current replacement
costs.
Inventory Costing

Last-In-First-Out (FIFO)
Inventory Costing

Last-In-First-Out (FIFO)
Inventory Costing

Average Cost
 Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

 Assumes goods are similar in nature.

 Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

 Relatively simple to implement

 parallel the physical flow of goods, where there is an

intermingling of identical inventory units (e.g. gasoline)
Inventory Costing

Average Cost
Inventory Costing

Average Cost
Inventory Costing

Financial Statement and Tax Effects

Perpetual Inventory Systems

Assuming the Perpetual Inventory System, compute Cost of Goods Sold

and Ending Inventory under FIFO, LIFO, and Average cost.
Perpetual Inventory System

First-In-First-Out (FIFO) Illustration 6A-2

Cost of Goods
Ending Inventory
Sold
Perpetual Inventory System

Last-In-First-Out (LIFO)

Cost of Goods
Ending Inventory
Sold
Perpetual Inventory System

Average-Cost

Cost of Goods Ending Inventory

Sold
Inventory Costing

Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Inventory Costing

Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Inventory Costing

Using Cost Flow Methods Consistently

 Method should be used consistently, enhances
comparability.
 Although consistency is preferred, a company may
change its inventory costing method.
Inventory Costing

Lower-of-Cost-or-Market
When the value of inventory is lower than its cost

 Companies can “write down” the inventory to its market

value in the period in which the price decline occurs.

 Market value = Replacement Cost

 Example of conservatism.

SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing

Lower-of-Cost-or-Market
Illustration: Assume that Ken TV has the following lines of
merchandise with costs and market values as indicated.

SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

 Lower-of-Cost-or-Market…
If market value is less than historical cost, the use of
LCM provides two advantages:
 LCM is supported by the matching principle.
The gross profit and net income are reduced for the
period in which the decline occurred, not in the
period in which it is sold.
 An approximately normal gross profit is realized
during the period in which the item is sold.
 Lower-of-Cost-or-Market…
LCM can be applied:
1. Item -by–item;
2. Major categories of inventories; or
3. Inventory as a whole
 Lower-of-Cost-or-Market…
Example:
LCM Rule applied to
Commodity Qty Unit Cost Unit RC Cost Market Items Group As a whole
A 400 $10.25 $9.50 $4,100 $3,800 $3,800
B 120 22.55 24.1 2,700 2,892 2,700
Total 6,800 6,692 6,692
C 600 8 7.75 4,800 4,650 4,650
D 280 14 14.75 3,920 4,130 3,920
Total 8,720 8,780 8,720
Total Inv. $15,520 $15,472 $15,070 15,412 $15,472
 Valuation at Net Realizable Value
 inventory may not be salable at normal sales due to
imperfections, shop wear, style changes, or other
causes.
 inventories should be written down to their NRV value as
there is a decline in utility (profit generating capacity).
 Net realizable value is the estimated selling price less any
direct cost of disposal, such as sales commission,
advertising, repairs etc.
 The valuation rule is cost or NRV whichever is lower.
 Example of conservatism.
 Example: Assume that damaged merchandise that had a cost of $1,500 can
be sold for only $1200. Direct costs of disposal are estimated as $150 for
maintenance and $200 for sales commission.
Inventory Errors

Common Cause:

 Failure to count or price inventory correctly.

 Not properly recognizing the transfer of legal title to

goods in transit.

 Errors affect both the income statement and balance

sheet.
Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods sold
and net income.
Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income in two periods.

 An error in ending inventory of the current period will have a

reverse effect on net income of the next accounting
period.

 Over the two years, the total net income is correct because
the errors offset each other.

 Ending inventory depends entirely on the accuracy of taking

and costing the inventory.
 Inventory Costing
2011 2012
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000

Combined income for ($3,000) $3,000

2-year period is correct. Net Income Net Income
understated overstated
Inventory Costing

Question
Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.
Inventory Costing

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:.
Statement Presentation

Presentation
Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from

sales.

There also should be disclosure of

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average).

Statement Presentation and Analysis

Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).

2. Low Inventory Levels – may lead to stockouts and lost

sales.

SO 6 Compute and interpret the inventory turnover ratio.

 Estimating Inventories
Some times, taking a physical inventory is impractical or
very costly or an independent check on the validity
of inventory figures is sought.
Reasons of estimation:
 To prepare interim financial statements in the case of
periodic system.
 To verify the reasonableness of the ending Inventory cost
 To know the amount of inventory that has been lost,
stolen, or destroyed.
Estimation methods:
 the retail method
 the gross profit method.
Methods of Estimating Inventories

Gross Profit Method

Estimates the cost of ending inventory by applying a gross profit
rate to net sales.
Estimating Inventories
Illustration: A Company’s records for January show net sales of
$200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. The company expects to earn a 30% gross
profit rate. Compute the estimated cost of the ending inventory at
January 31 under the gross profit method.
Estimating Inventories

Retail Inventory Method

Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.
Estimating Inventories

Illustration:

Note that it is not necessary to take a physical inventory to

determine the estimated cost of goods on hand at any given time.
 Exercises
H&M uses a periodic inventory system. H&M completed the
following inventory transactions during April:
April 1: Purchased 10 shirts @ $40
April 7: Sold 6 shirts for $70 each
April 13: Sold 2 shirts for $80 each
April 21: Purchased 3 shirts @ $50
Required:
1. Compute ending inventory, cost of goods sold and Gross
Profit assuming periodic system using FIFO and weighted
average cost flow assumptions .
2. Compute ending inventory, cost of goods sold and Gross
Profit assuming perpetual system using LIFO FIFO and
weighted average cost flow assumptions .