Financial Accounting: Inventory and Merchandising Operations

Financial Accounting
Eleventh Edition
Chapter 6
Inventory and
Merchandising
Operations
Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory (This Lecture)
➢Property, plant and equipment (Lecture 7)
Details of common liability accounts (Lecture 8)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

Learning Objectives
6.1 Understand the nature of inventory and retailing
operations
6.2 Record inventory-related transactions
6.3 Understand and apply different inventory cost
assumptions
6.4 Analyze effects of inventory errors
6.5 Evaluate a company’s retailing operations

Learning Objective 6.1
Understand the nature of inventory and retailing operations

Exhibit 6-1 Contrasting a Service Company
with a Merchandiser (1 of 2)
Merchandisers have two accounts that service entities don’t

need:
• Cost of goods sold on the income statement
• Inventory on the balance sheet
Exhibit 6-1 Contrasting a Service Company
with a Merchandiser (2 of 2)
Merchandisers have two accounts that service entities don’t

need:
• Cost of goods sold on the income statement
• Inventory on the balance sheet
Exhibit 6-2 Inventory and Cost of Goods
Sold When Inventory Cost Is Constant
Assume a retailer has in
stock 3 shirts that cost
$30 each. The store
sells 2 of the shirts for
$50 each.

Understand the nature of inventory
and retailing operations (1 of 2)
The cost of inventory sold shifts from asset to expense when
the seller delivers goods to the buyer.

Understand the nature of inventory
and retailing operations (2 of 2)
• Sales Price vs. Cost of Inventory
– Sales revenue is based on the sale price of inventory sold
– Cost of goods sold is based on the cost of inventory sold
– Inventory on the balance sheet is based on the cost of

inventory still on hand

Sale Price vs. Cost of Inventory (1 of 3)
Number of Units of Inventory
– Determined from accounting records
– Evidenced by physical count at year-end
– Consigned goods:
▪ Do not include those held for another company
▪ Include those out on consignment
– In transit goods treatment depends on shipping terms

Number of Units of Inventory
• Company with legal title to the goods while in transit pays
the transportation costs.
– FOB Shipping Point
▪ Ownership changes hands when the goods leave
the seller’s shipping dock, buyer pays shipping fee
– FOB Destination
▪ Ownership changes hands when the goods are
delivered to the customer, seller pays shipping fee

Shipping Terms
FOB Shipping Point

Seller Buyer
FOB Destination
Seller Buyer
• Cost per Unit Inventory
– Poses challenges due to differing prices throughout the
year

Record inventory-related transactions

Record Inventory-Related
Transactions (1 of 8)
Periodic Inventory System
• Used for inexpensive goods
• Does not keep a running record of all goods bought, sold, and
on hand, only update record when counted
• Inventory counted at least once a year
Perpetual Inventory System
• Used for all types of goods
• Keeps a running record of all goods bought, sold, and on hand
• Inventory counted at least once a year

• Recording Transactions in the
Perpetual System
▪ Recording inventory purchases
▪ Recording purchase returns
▪ Recording inventory sales
▪ Recording settlement discount

• Recording inventory purchases
Natalie ordered some clothing items from a manufacturer, with
shipping terms FOB shipping point. The freight-inwards (shipping
charge) for the order is $50. Freight-inwards is accounted for as
part of the cost of inventory.
Method 1: Directly record freight costs into inventory

• Recording inventory purchases
Method 2: Transfer freight costs into inventory with adjusting entry
Adjusting Entry

• Recording purchase returns
Suppose Natalie ordered blue jackets but received green ones.
She returned $100 worth of products and the vendor agreed to
deduct this from the amount due. Natalie would record the
following entry:

• Recording inventory sales
If Natalie sold a jacket that costs $15 for $25, she would record
the following journal entry:

• Recording settlement discount
Natalie ordered goods from a different vendor for $1,000. This
vendor offers a “2/10, n/30” (2% discount if paid within 10 days,
otherwise the invoiced amount due within 30 days) with free
shipping and handling. On receiving the goods, Natalie recorded
the following:

• Recording settlement discount
Suppose Natalie decides to take advantage of the early settlement
discount, the 2% discount is confirmed when the payment is
made:
Inventory is the cost of acquiring the goods, lower purchase price

lowers inventory.

Understand and apply different inventory cost assumptions

Understand and Apply Different
Inventory Cost Assumptions (1 of 9)
• The cost of any asset, such as inventory, is the sum of all
the costs incurred to bring the asset to its intended use,
less any discounts. Cost includes:
– Purchase price
– Freight in
– Insurance while in transit
– Fees/taxes to get inventory ready to sell
– Less: returns, allowances, and discounts

• Problem: inventory price often changes with time. When
you purchase the same product at different time at different
prices, how do you determine the cost of the good you are
selling?
• Accounting uses four generally accepted inventory
methods:
– Specific Identification
– First-in, first-out (FIFO) cost
– Last-in, first-out (LIFO) cost
– Average cost

Exhibit 6-7 Inventory Data Used to Illustrate
the Various Inventory Costing Methods
• The Problem:

• Specific Identification
– Used for businesses with unique inventory items
– E.g. automobiles, antique furniture, real estate
– Businesses cost their inventories at the specific cost of
the particular unit
– Also called the specific unit cost
– Too expensive for inventories with common
characteristics

• First-in, first out (FIFO)
– First costs into inventory are the first costs assigned to
cost of goods sold
– Ending inventory is based on the latest costs incurred

FIFO Cost

• Last-in, first-out (LIFO)
– Costing is the opposite of FIFO
– Last costs into inventory go immediately to cost of
goods sold
– Ending inventory is based on the oldest costs

LIFO Cost

• Average Cost
– Also called the weighted-average method
– Based on the average cost of inventory during the
period

Average Cost Method (1 of 2)
Cost of goods available1 $900

Averagecost per unit = = = $15
Number of units available 60
Cost of goods sold = Number of units sold  Average cost per unit
= 40 units  $15 = $600
Ending inventory = Number of units on hand  Average cost per unit

= 20 units  $15 = $300

Average Cost Method (2 of 2)
• Next opening balance become $15 per unit

Timing of the Purchase and Cost
In the prior example, all the purchase orders are given on

one side without purchase date, so we average the costs for
the whole period.
In the exam, if a schedule like this is given, you need to
calculate the average costs again after each purchase order.
Timing of the Purchase and Cost
After Mar 8, average cost become: ((38x30)+(39x77))/107

=38.7196
If we do like the example, the cost instead become:
((38x48)+(39x77)+(40x17))/(48+77+17)=38.7817

Exhibit 6-8 Financial Statement Effects of the
FIFO, LIFO, and Average Cost Inventory
Methods

Exhibit 6-9 Cost of Goods Sold and Ending
Inventory—FIFO and LIFO; Increasing Costs and
Decreasing Costs
Panel A –– When Inventory Costs Are Increasing (Newer cost higher)
blank Cost of Goods Sold (COGS) Ending Inventory (EI)
FIFO FIFO COGS is lowest. Gross FIFO EI is highest.
profit is therefore the highest.
LIFO LIFO COGS is highest. Gross LIFO EI is lowest.
profit is therefore the lowest.
Panel B –– When Inventory Costs Are Decreasing (Newer cost lower)

blank Cost of Goods Sold (COGS) Ending Inventory (EI)
FIFO FIFO COGS is highest. Gross FIFO EI is lowest.
profit is therefore the lowest.
LIFO LIFO COGS is lowest. Gross LIFO EI is highest.
profit is therefore the highest.

• Comparability as an Enhancing Qualitative
Characteristic
– Use same accounting methods periodically
– However, lack of (short-term) comparability should not
prevent the accounting method change, if the change
reflects a more relevant and faithful representation of
the underlying economic phenomenon
– Disclose the effect of the change on net income

• Why is LIFO not allowed under IFRS?
– LIFO prioritizes income measurements over that of
assets and liabilities, but IFRS (Conceptual
Framework) favors Balance Sheet primacy
– LIFO can create unrealistic profits (when dipping into
very old inventory costs)
– LIFO lacks representation faithfulness of inventory
flows (companies generally do not sell newer goods
first)

• Net Realizable Value (NRV)
– IAS 2 requires inventories to be measured at the lower
of cost and net realizable value
– The estimated selling price less the estimated costs of
completion and the estimated costs necessary to make
the sale
– Necessary as an entity may not be able to recover the
cost of inventory if the goods are damaged or obsolete,
or if their selling price has declined below costs.

Example of Inventory write down
⚫ The company has inventory of 1000 by period end.
However, some of the inventory has been damaged and
the NRV of the inventory is 400. The original cost of
goods sold is 2000.
⚫ Write-down of inventory: when cost of inventory is below
NRV.
⚫ Write-down is recognized into cost of goods sold.

Exhibit 6-10 Net Realizable Value (NRV) Effects
on Inventory and Cost of Goods Sold

Analyze the effects of inventory errors

Analyze the Effects of Inventory
Errors
• An error in ending inventory creates errors for 2
accounting periods
• Exhibit 6-12 Effects of Inventory Errors

Exhibit 6-11 Inventory Errors

Evaluate a company’s retailing operations

Evaluate a Company’s Retailing
Operations (1 of 8)
Gross Profit Percentage
• Key indicator of company’s ability to sell inventory at a profit
• Merchandisers strive to increase this ratio
• Gross profit stated as a percentage of sales
• Watched carefully by managers and investors
• Gross profit = Sales − Cost of Goods Sold
Gross profit
Gross profit percentage =
Net sales revenue

Operations (2 of 8)
Gross profit percentage is computed as follows for FR.

Operations (3 of 8)
Inventory turnover and resident period
• Ratio of cost of goods sold to average inventory
• Indicates how rapidly inventory is sold (how many times
the inventory is sold per year)
• Varies from industry to industry
cost of goods sold Cost of goods sold
Inventory turnover = =
Average inventory (Beginning inventory + Ending inventory )
2

Operations (4 of 8)
Resident period
• Average amount of time inventory was on the shelves
– 365/Inventory Turnover

Operations (5 of 8)
Cost-of-Goods-Sold Model
• Captures all inventory information for an entire accounting
period

Operations (6 of 8)
• Gross Profit Method
– Sometimes it is necessary for a business to estimate
the value of goods on hand
– Widely used to estimate ending inventory, because
gross profit is quite stable for mature business, and
concrete reference (prior records) can be provided
– Rearrange COGS model

Operations (7 of 8)
• Cost of goods sold can be reasonably estimated by

previous profit margin

Operations (8 of 8)
Suppose a fire damaged all the goods, and you need to
estimate the inventory lost to claim insurance, you can
estimate COGS and ending inventory as shown below:

Chapter Summary
• For merchandise businesses, the goods in possession are
recorded as Inventory on the balance sheet, and are
converted into Cost of Goods Sold when sold
• Inventory consist of all costs incurred to acquiring it, in
which the shipping costs burden is indicated by the FOB
shipping terms
• Since the costs of inventory usually changes with time, we
have 4 kinds of inventory flow assumptions:
Specific identification, FIFO, LIFO, average cost
and LIFO is not allowed in IFRS

Chapter Summary
• If the value of inventory is less than the net realizable
value, it needs to be written-down
• Inventory errors affect 2 accounting periods, so it should
be treated carefully

Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory ✓
➢Property, plant and equipment (Next Lecture)
Details of common liability accounts (Lecture 8)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

Course Overview
Financial Statement Analysis:
•Current Ratio
•Receivable Turnover
•Gross Profit
•Inventory Turnover (Residence Period)

Homework Assignments
• E6-20A

Tutorial 1
• Time to be determined
• Review topics in Chapter 1-6
• Optional

Midterm Exam
• 28 Oct (Wed)
• 7:00 – 9:00pm
• On Blackboard
• Covers lecture 1-6 (up to this chapter)

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Financial Accounting

Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Merchandisers have two accounts that service entities don’t

Merchandisers have two accounts that service entities don’t

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– Inventory on the balance sheet is based on the cost of

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FOB Shipping Point

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Inventory is the cost of acquiring the goods, lower purchase price

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Cost of goods available1 $900

Ending inventory = Number of units on hand  Average cost per unit

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• Next opening balance become $15 per unit

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In the prior example, all the purchase orders are given on

After Mar 8, average cost become: ((38x30)+(39x77))/107

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Panel B –– When Inventory Costs Are Decreasing (Newer cost lower)

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