Accounting Principles, 7th Edition

Weygandt • Kieso • Kimmel

Chapter 6

Inventories

Prepared by Naomi Karolinski

Monroe Community College
and
Marianne Bradford
Bryant College

John Wiley & Sons, Inc. © 2005

 CHAPTER 6

INVENTORIES
After studying this chapter, you should be able to:
1 Describe steps in determining inventory quantities
2 Explain the basis of accounting for inventories
and describe the inventory cost flow methods
3 Explain the financial statements and the tax
effects of each inventory cost flow method
4 Explain the lower of cost or market basis of
accounting for inventories
5 Indicate the effects of inventory errors on the
financial statements
6 Compute and interpret inventory turnover
 INVENTORY BASICS

• Balance sheet of merchandising and

manufacturing companies
– inventory significant current asset
• Income statement
– inventory is vital in determining results
• Gross profit
– (net sales - cost of goods sold)
• watched by management, owners, and others
MERCHANDISE INVENTORY
CHARACTERISTICS
Merchandise inventory
1 Owned by the company
2 In a form ready for sale
 CLASSIFYING INVENTORY IN A
MANUFACTURING ENVIRONMENT

•Manufacturing inventories
– may not yet be ready for sale
•Classified into three categories:
1 Finished goods
ready for sale
2 Work in process
various stages of production
(not completed)
3 Raw materials
components on hand waiting to be used
DETERMINING INVENTORY
QUANTITIES
STUDY OBJECTIVE 1

To prepare financial statements determine

1. the number of units in inventory by taking a

physical inventory of goods on hand physical
inventory by counting, weighing or measuring
2. The ownership of goods
 DETERMINING COST
OF GOODS ON HAND
3. apply unit costs to the total units on
hand for each item
4. total the cost of each item of inventory to
determine total cost of goods on hand
TAKING A PHYSICAL INVENTORY

Internal control principles for inventory:

1 Segregation of duties
counting by employees not having
custodial responsibility for the inventory
2 Establishment of responsibility
each counter should establish the
authenticity of each inventory item
TAKING A PHYSICAL INVENTORY

3 Independent internal verification

second count by another employee
4 Documentation procedures
pre-numbered inventory tags
5 Independent internal verification
designated supervisor checks all inventory
items tags, no items have more than one
tag
OWNERSHIP OF GOODS IN
TRANSIT
• Goods in transit:
included in the inventory of the party that has
legal title to the goods
• FOB (Free on Board) shipping point:
ownership of the goods passes to the buyer when
the public carrier accepts the goods from the seller
• FOB destination point:
legal title to the goods remains with the seller until
the goods reach the buyer
TERMS OF SALE
 CONSIGNED GOODS
Consignment:
the holder of the goods (consignee) does
not own the goods
– ownership remains with the consignor of
the goods until the goods are sold
– consigned goods should be included in the
consignor’s inventory, not the consignee’s
inventory

Owned by a consignor; do not

count in consignee
inventory
Consignee Company
 INVENTORY ACCOUNTING
SYSTEMS

1 Perpetual
• detailed records
• cost of each item maintained
• cost of each item sold is determined when
sale occurs
2 Periodic
• cost of goods sold is determined at the end
of accounting period
Basis of Accounting for Inventories
Periodic Cost Flow Methods
STUDY OBJECTIVE 2

• Revenues from the sale of merchandise are

recorded when sales are made in the same way
as in a perpetual system.
• No calculation of cost of goods sold is made at
the time of sale of the merchandise.
• Physical inventories are taken at end of period
to determine:
– the cost of merchandise on hand
– the cost of the goods sold during the period
 ALLOCATING
INVENTORIABLE COSTS
• Inventory costs- periodic inventory system
– allocated between ending inventory and cost of goods sold
– allocation is made at the end of the accounting period
1 the costs assignable to the ending inventory are
determined
2 the cost of the ending inventory is subtracted
from the cost of goods available for sale to
determine the cost of goods sold
3 cost of goods sold is then deducted from sales
revenues in accordance with the matching
principle to get gross profit
 COST OF GOODS SOLD

Cost of Goods Sold –Review

Periodic inventory system
Three steps are required:
1. record purchases of merchandise,
2. determine the cost of goods
purchased,
3. determine the cost of goods on hand
at the beginning and end of the
accounting period
 DETERMINING COST OF
GOODS PURCHASED

To determine Cost of Goods Purchased:

1 subtract contra purchase accounts of
Purchases Discounts and Purchases
Returns and Allowances from
Purchases to get Net Purchases
2 add Freight-in to Net Purchases
ALLOCATION (MATCHING) OF
POOL OF COSTS
STUDY OBJECTIVE 5

$ 120,000

$15,000 $105,000
The cost of goods available for sale is
allocated between
a. beginning inventory and ending inventory.
b. beginning inventory and cost of goods on hand.
c. cost of goods purchased and cost of goods sold.
d. beginning inventory and cost of goods purchased.
The cost of goods available for sale is
allocated between
a. beginning inventory and ending inventory.
b. beginning inventory and cost of goods on hand.
c. cost of goods purchased and cost of goods sold.
d. beginning inventory and cost of goods purchased.
 USING ACTUAL PHYSICAL
FLOW COSTING
• Costing of the inventory is complicated because
specific items of inventory on hand may have
been purchased at different prices.
• The specific identification method tracks the
actual physical flow of the goods.
• Each item of inventory is marked, tagged, or
coded with its specific unit cost.
• Items still in inventory at the end of the year are
specifically costed to arrive at the total cost of
the ending inventory.
SPECIFIC IDENTIFICATION
METHOD
USING ASSUMED COST FLOW
METHODS
• Other cost flow methods are allowed since
specific identification is often impractical.
• These methods assume flows of costs that may be
unrelated to the physical flow of goods.
• For this reason we call them assumed cost flow
methods or cost flow assumptions. They are:
1 First-in, first-out (FIFO).
2 Last-in, first-out (LIFO).
3 Average cost.
 FIFO
• The FIFO method
– earliest goods purchased are the first to be sold.
– often parallels the actual physical flow of
merchandise.
– the costs of the earliest goods purchased are the
first to be recognized as cost of goods sold.
FIFO
ALLOCATION OF COSTS - FIFO
METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 $ 12,000

$ 5,800 $ 6,200
PROOF OF COST OF
GOODS SOLD
The accuracy of the cost of goods sold
can be verified by recognizing that the
first units acquired are the first units sold.

Unit Total
Date Units Cost Cost
01/01 100 X
$ 10 $ 1,000 =
04/15 X = 200
11 2,200
08/24 X =
250
Total 12 3,000
550 $ 6,200
 LIFO
• The LIFO method assumes that the latest
goods purchased are the first to be sold.
• LIFO seldom coincides with the actual
physical flow of inventory.
• Under LIFO, the costs of the latest goods
purchased are the first goods to be sold.
LIFO
ALLOCATION OF COSTS - LIFO
METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total
$ 12,000 1,000

$ 5,000 $ 7,000
 PROOF OF COST OF
GOODS SOLD
The cost of the last goods in are the first to be assigned
to cost of goods sold. Under a periodic inventory
system, all goods purchased during the period are
assumed to be available for the first sale, regardless of
the date of purchase.

Unit Total
Date Units Cost Cost
11/27 400
X
$ 13 $ 5,200
=
08/24 150
X 12
=1,800
Total 550 $ 7,000
 AVERAGE COST

• The average cost method

– assumes goods available for sale are homogeneous.
– the cost of goods available for sale is allocated on
the basis of the weighted average unit cost
incurred.
– weighted average unit cost is applied to the units on
hand to determine cost of the ending inventory.
AVERAGE COST
ALLOCATION OF COSTS -
AVERAGE COST METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total $ 12,000 1,000

$ 5,400 $ 6,600
USE OF COST FLOW METHODS IN
MAJOR U.S. COMPANIES
Companies adopt different inventory cost flow methods
for various reasons. Usually one of the following factors is
involved: 1) income statement effects, 2) balance sheet
effects, or 3) tax effects.

21%
5% Other Average
Cost 44%
FIFO
30%
LIFO
A company had the following inventory information for the month
of May:
May 1 Beg. 400 @ $10.00 = $ 4,000
Inventory units
8 Purchase 500 @ $10.50 = $ 5,250
units
20 Purchase 600 @ $10.60 = $ 6,360
units
Total units 1,100 $15,610

Assuming the company is using the Lifo method of inventory:

Calculate the value of the ending inventory if there are 100 units in ending
inventory on May 31st.
Under LIFO, the ending inventory consists of the
oldest 100 units, therefore ending inventory = 100
units X $10 = $1,000.
INCOME STATEMENT EFFECTS
COMPARED
STUDY OBJECTIVE 3

Kralik Company buys 200 XR492s at $20 per unit on

January 10 and 200 more on December 31 at $24 each.
During the year, 200 units are sold at $30 each. Under
LIFO, the company recovers the current replacement
cost ($4,800) of the units sold. Under FIFO, however, the
company recovers only the January 10 cost ($4,000). To
replace the units sold, it must invest $800 (200 x $4) of
the gross profit. Thus, $800 of the gross profit is said to
be phantom or illusory profits. As a result, reported net
income is overstated in real terms.

LIFO FIFO
Cost of goods sold 4,000 (200 x $20) 4,800 (200 x $24)
USING INVENTORY COST FLOW
METHODS CONSISTENTLY
• Consistency
– Companies needs to use its chosen cost flow
method from one period to another.
– Consistent application makes financial
statements comparable over successive time
periods.
– If a company adopts a different cost flow
method:
• The change and its effects on net income must be
disclosed in the financial statements
VALUING INVENTORY AT THE
LOWER OF COST OR MARKET
STUDY OBJECTIVE 4

• Value of inventory is lower than its

cost
– The inventory is written down to its
market value
• Known as the lower of cost or market
(LCM) method
• LCM basis
– Market is defined as current replacement
cost, not selling price
COMPUTATION OF LOWER
OF
COST OR MARKET

$ 159,000
INVENTORY ERRORS - INCOME
STATEMENT EFFECTS
STUDY OBJECTIVE 5

• both beginning and ending inventories

appear on the income statement
• ending inventory of one period
automatically becomes the beginning
inventory of the next period
• inventory errors
– affect the determination of cost of
goods sold and net income
 FORMULA FOR
COST OF GOODS SOLD

Cost of Cost of
Beginning _ Ending
+ Goods = Goods
Inventory Inventory
Purchased Sold

the effects on cost of goods sold can

be determined by entering the
incorrect data in the above formula and
then substituting the correct data
 EFFECTS OF INVENTORY
ERRORS ON CURRENT YEAR’S
INCOME STATEMENT

Understate beginning inventory Understated Overstated

Overstate beginning inventory Overstated Understated
Understate ending inventory Overstated Understated
Overstate ending inventory Understated Overstated

An error in ending inventory of the current period will have a reverse effect on
net income of the next period.
ENDING INVENTORY ERROR -
BALANCE SHEET EFFECTS

the effect of ending inventory errors on the balance sheet can be determined
by the basic accounting equation:

Assets = Liabilities + Owners Equity

ENDING INVENTORY ERROR -
BALANCE SHEET EFFECTS

Errors in the ending inventory have the following effects on these

components:

Overstated Overstated None Overstated Understated Understated

None Understated
 INVENTORY DISCLOSURES
• Inventory
– classified as a current asset after receivables in the balance
sheet
• Cost of goods sold
– subtracted from sales in the income statement

•Disclosure either in the balance sheet or in

accompanying notes for:
1 major inventory classifications
2 basis of accounting (cost or lower of cost or market)
3 costing method (FIFO, LIFO, or average cost)

Wal-Mart Stores, Inc

Notes to the Financial Statements
Note 1. Summary of accounting policies
Inventories
The company uses the retail, last-in, first-out (LIFO) method for the Wal-Mart Stores segment, cost LIFO for the
SAM’S CLUB segment, and other cost methods, including the retail first-in, first-out (FIFO) and average costs
methods, for the International segment. Inventories are not recorded in excess of market value.
 INVENTORY TURNOVER
FORMULA AND COMPUTATION
STUDY OBJECTIVE 6

The inventory turnover ratio measures the number of times, on

average, the inventory is sold during the period – which
measures the liquidity of the inventory. It is computed by
dividing cost of goods sold by average inventory during the year.
Assume that Wal-Mart, Inc. has a beginning inventory of $21,442
million and ending inventory of $21,614 and cost of goods sold
for 2002 of $171,562; its inventory turnover formula and
computation is shown below:

COST OF GOODS SOLD

INVENTORY TURNOVER =
————————————

7.97 times = $171,562

AVERAGE
INVENTORY ($21,442 + $21,614) /2
 APPENDIX 6A
INVENTORY COST FLOW METHODS IN
PERPETUAL INVENTORY SYSTEMS

To illustrate the application of the 3 assumed

cost flow methods (FIFO, Average Cost, and
LIFO), the data shown below for Bow Valley
Electronics’ product Z202 Astro Condenser is
used.

Bow Valley Electronics

Z202 Astro Condensers
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total $ 12,000
 PERPETUAL SYSTEM - FIFO

Under FIFO, the cost of the earliest goods on hand prior to each
sale is charged to cost of goods sold. Therefore, the cost of goods
sold on September 10 consists of the units on hand January 1 and
the units purchased April 15 and August 24.
 PERPETUAL SYSTEM - LIFO
Under the LIFO method using a perpetual system, the cost of
the most recent purchase prior to sale is allocated to the
units sold. The cost of the goods sold on September 10
consists entirely of goods from the August 24 and April 15
purchases and 50 of the units in beginning inventory.
 PERPETUAL SYSTEM -
AVERAGE COST
The average cost method in a perpetual inventory
system is called the moving average method.
Under this method a new average is computed
after each purchase. The average cost is
computed by dividing the cost of goods
available for sale by the units on hand. The
average cost is then applied to
1. the units sold, to determine the cost of goods
sold, and,
2. the remaining units on hand, to determine the
ending inventory amount.
 PERPETUAL SYSTEM -
AVERAGE COST METHOD
As indicated below, a new average is computed each time a purchase is made.
On April 15, after 200 units are purchased for $2,200, a total of 300 units costing
$3,200 ($1,000 + $2,200) are on hand. The average cost is $10.667 ($3,200/300).
 APPENDIX 6B
ESTIMATING INVENTORIES
• Two circumstances for estimating
inventories:
1 management may want monthly or quarterly
financial statements, but a physical inventory
is usually only taken annually.
2 a casualty such as a fire or flood may make it
impossible to take a physical
inventory.
•Two widely used methods of estimating
inventories:
1 the gross profit method and
2 the retail inventory method
 GROSS PROFIT METHOD

• Gross profit method

– Estimates the cost of ending inventory by
applying a gross profit rate to net sales
• used in preparing monthly financial
statements under a periodic system
• should NOT be used in preparing the
company’s financial statements at year-end
• is assumed to remain constant from one year
to the next
 GROSS PROFIT METHOD
FORMULAS
Step 1 Net sales less estimated gross profit equals estimated cost of goods sold.

Estimated Estimated
Net Sales Gross Cost of
Profit Goods Sold

Estimated Estimated
Cost of Goods
Cost of Cost of
Available for
Goods Sold Ending
Sale
Inventory

Step 2 Cost of goods available for sale less estimated cost

of goods sold (from Step 1) equals the estimated cost of
ending inventory.
 RETAIL INVENTORY
METHOD
• A store has many different types of
merchandise at low unit costs
– the retail inventory method is often used
– a company’s records must show both the
cost and retail value of the goods available
for sale
• Major disadvantage
– it is an averaging technique
 RETAIL INVENTORY
METHOD FORMULAS

Step Goods Ending

Available for Net Sales Inventory
1 at Retail
Sale at Retail

Step Goods Goods Cost to

Available for Available for Retail
2 Ratio
Sale at Cost Sale at Retail

Ending Cost to Estimated

Step Cost of
Inventory Retail
3 at Retail Ratio
Ending
Inventory
 DETERMINING COST
OF GOODS ON HAND
Under the periodic method, cost of
inventory on hand is determined from a
physical inventory requiring:
1 counting the units on hand for each
item of inventory
2 applying unit costs to the total units on
hand for each item
3 totaling the cost of each item of inventory
to determine total cost of goods on hand
A company had the following inventory
information for the month of May:
May 1 Beg. Inventory 400 units @ $10.00 = $ 4,000
8 Purchase 500 units @ $10.50 = $ 5,250
20 Purchase 600 units @ $10.60 = $ 6,360
Total units and cost 1,500 $15,610
Assuming the company is using the LIFO method of inventory:
Calculate the value of the ending inventory if there are 100 units in
ending inventory on May 31.
A company had the following inventory
information for the month of May:
May 1 Beg. 400 @ $10.00 = $ 4,000
Inventory units
8 Purchase 500 units @ $10.50 = $ 5,250
20 Purchase 600 units @ $10.60 = $ 6,360
Total units and cost 1,500 $15,610
Assume an ending inventory of 100 units, then ending inventory would
consist of the oldest layer:
100 units @ $10.00 = $1,000
(Cost of Goods sold would be equal to (Cost of Goods available for
Sale - Ending Inventory) $15,610-$1,000= $14,610
 COPYRIGHT

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