Chapter one: Inventory (IAS 2)

1.1. Internal control of inventories

The cost of inventory is a significant item in many businesses’ financial statements. Inventory is used to
indicate (1) merchandise held for sale in the normal course of business and (2) materials in the process of
production or held for production. In this chapter, we focus primarily on inventory of merchandise
purchased for resale.

The cost of merchandise is its purchase price, less any purchases discounts. Merchandise inventory also
includes other costs, such as transportation, import duties, and insurance against losses in transit. Not only
must the cost inventory be determined, but good internal control over inventory must also be maintained.
Two primary objectives of internal control over inventory are safeguarding the inventory and properly
reporting it in the financial statements. These internal controls can be either preventive or detective in
nature. A preventive control is designed to prevent errors or misstatements from occurring. A detective
control is designed to detect an error or misstatement after it has occurred.

Control over inventory should begin as soon as the inventory is received. Prenumbered receiving reports
should be completed by the company’s receiving department in order to establish the initial accountability
for the inventory. To make sure the inventory received is what was ordered, each receiving report should
agree with the company’s original purchase order for the merchandise. Likewise, the price at which the
inventory was ordered, as shown on the purchase order, should be compared to the price at which the
vendor billed the company, as shown on the vendor’s invoice. After the receiving report, purchase order,
and vendor’s invoice have been reconciled, the company should record the inventory and related account
payable in the accounting records.

Controls for safeguarding inventory include developing and using security measures to prevent inventory
damage or employee theft. For example, inventory should be stored in a warehouse or other area to which
access is restricted to authorized employees. The removal of merchandise from the warehouse should be
controlled by using requisition forms, which should be properly authorized. The storage area should also be
climate controlled to prevent damage from heat or cold. Further, when the business is not operating or is
not open, the storage area should be locked.

When shopping, you may have noticed how retail stores protect inventory from customer theft. Retail stores
often use such devices as two-way mirrors, cameras, and security guards. High priced items are often
displayed in locked cabinets. Retail clothing stores often place plastic alarm tags on valuable items such as
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leather coats. Sensors at the exit doors set off alarms if the tags have not been removed by the clerk.
These controls are designed to prevent customers from shoplifting.

Using a perpetual inventory system for merchandise also provides an effective means of control over
inventory. The amount of each type of merchandise is always readily available in a subsidiary inventory
ledger. In addition, the subsidiary ledger can be an aid in maintaining inventory quantities at proper levels.
Frequently comparing balances with predetermined minimum and maximum levels allows for timely
reordering and prevents ordering excess inventory.

To ensure the accuracy of the amount of inventory reported in the financial statements, a merchandising
business should take a physical inventory (i.e., count the merchandise). In a perpetual inventory system,
the physical inventory is compared to the recorded inventory in order to determine the amount of shrinkage
or shortage. If the inventory shrinkage is unusually large, management can investigate further and take any
necessary corrective action.

Knowledge that a physical inventory will be taken also helps prevent employee thefts or misuses of
inventory. The first step in this process is to determine the quantity of each kind of merchandise owned by
the business. A common practice is to use teams of two persons. One person determines the quantity, and
the other lists the quantity and description on inventory count sheets. Quantities of high-cost items are
usually verified by supervisors or a second count team.

All the merchandise owned by the business on the inventory date should be included. For merchandise in
transit, the party (the seller or the buyer) who has title to the merchandise on the inventory date is the
owner. To determine who has title, it may be necessary to examine purchases and sales invoices of the
last few days of the current period and the first few days of the following period.

Shipping terms determine when title passes. When goods are purchased or sold FOB shipping point, title
passes to the buyer when the goods are shipped. When the terms are FOB destination, title passes to the
buyer when the goods are delivered. Manufacturers sometimes ship merchandise to retailers who act as
the manufacturer’s agent when selling the merchandise. The manufacturer retains title until the goods are
sold. Such merchandise is said to be shipped on consignment to the retailers. The unsold merchandise is a
part of the manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the
retailers. The consigned merchandise should not be included in the retailer’s (consignee’s) inventory.

1.2. The effect of inventory errors on the financial statements

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Any errors in the inventory count will affect both the balance sheet and the income statement. For example,
an error in the physical inventory will misstate the ending inventory, current assets, and total assets on the
balance sheet. This is because the physical inventory is the basis for recording the adjusting entry for
inventory shrinkage. Also, an error in taking the physical inventory misstates the cost of goods sold, gross
profit, and net income on the income statement. In addition, because net income is closed to the owner’s
equity at the end of the period, owner’s equity will also be misstated on the balance sheet. This
misstatement of owner’s equity will equal the misstatement of the ending inventory, current assets, and
total assets.

To illustrate, assume that in taking the physical inventory on December 31, 2006, Sapra Company
incorrectly recorded its physical inventory as $115,000 instead of the correct amount of $125,000. As a
result, the merchandise inventory, current assets, and total assets reported on the December 31, 2006
balance sheet would be understated by $10,000 ($125,000 - $115,000). Because the ending physical
inventory is understated, the inventory shrinkage and the cost of merchandise sold will be overstated by
$10,000. Thus, the gross profit and the net income for the year will be understated by $10,000. Since the
net income is closed to owner’s equity at the end of the period, the owner’s equity on the December 31,
2006 balance sheet will also be understated by $10,000. The effects on Sapra Company’s financial
statements are summarized as follows:
Amount of Misstatement
Balance Sheet:
Merchandise inventory understated $(10,000)
Current assets understated (10,000)
Total assets understated (10,000)
Owner’s equity understated (10,000)
Income Statement:
Cost of merchandise sold overstated $ 10,000
Gross profit understated (10,000)
Net income understated (10,000)
Errors in the physical inventory are normally detected in the period after they occur. In such cases, the
financial statements of the prior year must be corrected.

1.3. Inventory cost flow assumptions

A major accounting issue arises when identical units of merchandise are acquired at different unit costs
during a period. In such cases, when an item is sold, it is necessary to determine its unit cost so that the
proper accounting entry can be recorded.

To illustrate, assume that three identical units of Item X are purchased during May, as shown below.

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 Item X Units Cost
May 10 Purchase 1 $9
18 Purchase 1 13
24 Purchase 1 14
Total 3 $36
Average cost per unit $12

Assume that one unit is sold on May 30 for $20. If this unit can be identified with a specific purchase, the
specific identification method can be used to determine the cost of the unit sold. For example, if the unit
sold was purchased on May 18, the cost assigned to the unit is $13 and the gross profit is $7 ($20 - $13). If,
however, the unit sold was purchased on May 10, the cost assigned to the unit is $9 and the gross profit is
$11 ($20 - $9).

The specific identification method is not practical unless each unit can be identified accurately. An
automobile dealer, for example, may be able to use this method, since each automobile has a unique serial
number. For many businesses, however, identical units cannot be separately identified, and a cost flow
must be assumed. That is, which units have been sold and which units are still in inventory must be
assumed. There are three common cost flow assumptions used in business. Each of these assumptions is
identified with an inventory costing method, as shown below:
1. First-in, first-out (FIFO): Cost flow is in the order in which the costs were incurred. When this method is
used, the ending inventory is made up of the most recent costs.
2. Last-in, first-out (LIFO): Cost flow is in the reverse order in which the costs were incurred. When this
method is used, the ending inventory is made up of the earliest costs.
3. Average cost: Cost flow is an average of the costs. When the average cost method is used, the cost of
the units in inventory is an average of the purchase costs.
To illustrate, we use the preceding example to prepare the income statement for May and the balance
sheet as of May 31 for each of the cost flow methods, again assuming that one unit is sold. These financial
statements are shown below:

Fifo Method
Income Statement Balance Sheet
Sales $20 Merchandise inventory $27
Cost of merchandise sold 9
Gross profit $11
Lifo Method
Income Statement Balance Sheet
Sales $20 Merchandise inventory $22
Cost of merchandise sold 14
Gross profit $6

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 Average Cost Method
Income Statement Balance Sheet
Sales $20 Merchandise inventory $24
Cost of merchandise sold 12
Gross profit $8

As you can see, the selection of an inventory costing method can have a significant impact on the financial
statements. For this reason, the selection has important implications for managers and others in analyzing
and interpreting the financial statements.

1.4. Inventory costing methods under a perpetual inventory system

In a perpetual inventory system, all merchandise increases and decreases are recorded. The merchandise
inventory account at the beginning of an accounting period indicates the merchandise in stock on that date.
When identical units of an item are purchased at different unit costs during a period, a cost flow must be
assumed. In such cases, the fifo, lifo, or average cost method is used. We illustrate each of these methods,
using the data shown below:
Item XX Units Cost
Jan. 1 Inventory 10 $20
4 Sale 7
10 Purchase 8 21
22 Sale 4
28 Sale 2
30 Purchase 10 22
First-In, First-Out Method
When the fifo method of costing inventory is used, costs are included in the cost of merchandise sold in the
order in which they were incurred.

To illustrate based on the above data, lets journalize entries for purchases and sales and the inventory
subsidiary ledger account for Item XX. The number of units in inventory after each transaction, together
with total costs and unit costs, are shown in the account. We assume that the units are sold for $30 each
on account.

Journal Page 1
Jan. 4 Account receivable 210
Sales 210
4 Cost of merchandise sold 140
Merchandise inventory 140
10 Merchandise inventory 168
Accounts payable 168
22 Accounts receivable 120
Sales 120

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 22 Cost of merchandise sold 81
Merchandise inventory 81
28 Account receivable 60
Sales 60
28 Cost of merchandise sold 42
Merchandise inventory 42
30 Merchandise inventory 220
Accounts payable 220

Item XX
Purchases Cost of Merchandise Sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 3 20 60
1 21 21 7 21 147
28 2 21 42 5 21 105
30 10 22 220 5 21 105
10 22 220

You should note that after the 7 units were sold on January 4, there was an inventory of 3 units at $20
each. The 8 units purchased on January 10 were acquired at a unit cost of $21, instead of $20. Therefore,
the inventory after the January 10 purchase is reported on two lines, 3 units at $20 each and 8 units at $21
each. Next, note that the $81 cost of the 4 units sold on January 22 is made up of the remaining 3 units at
$20 each and 1 unit at $21. At this point, 7 units are in inventory at a cost of $21 per unit. The remainder of
the illustration is explained in a similar manner.

Last-In, First-Out Method

When the lifo method is used in a perpetual inventory system, the cost of the units sold is the cost of the
most recent purchases. To illustrate, the journal entries for purchases and sales and the subsidiary ledger
account for Item XX, prepared on a lifo basis below.

Journal Page 1
Jan. 4 Account receivable 210
Sales 210
4 Cost of merchandise sold 140
Merchandise inventory 140
10 Merchandise inventory 168
Accounts payable 168
22 Accounts receivable 120

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 Sales 120
22 Cost of merchandise sold 84
Merchandise inventory 84
28 Account receivable 60
Sales 60
28 Cost of merchandise sold 42
Merchandise inventory 42
30 Merchandise inventory 220
Accounts payable 220

Item XX
Purchases Cost of Merchandise Sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 4 21 84 3 20 60
4 21 84
28 2 21 42 3 20 60
2 21 42
30 10 22 220 3 20 60
2 21 42
10 22 220

When the lifo method is used, the inventory ledger is sometimes maintained in units only. The units are
converted to dollars when the financial statements are prepared at the end of the period. The use of the lifo
method was originally limited to rare situations in which the units sold were taken from the most recently
acquired goods. For tax reasons, which we will discuss later, its use has greatly increased during the past
few decades. Lifo is now often used even when it does not represent the physical flow of goods.

Average Cost Method

When the average cost method is used in a perpetual inventory system, an average unit cost for each type
of item is computed each time a purchase is made. This unit cost is then used to determine the cost of
each sale until another purchase is made and a new average is computed. This averaging technique is
called a moving average. Since the average cost method is rarely used in a perpetual inventory system, we
do not illustrate it in this chapter.

1.5. Inventory costing methods under a periodic inventory system

When the periodic inventory system is used, only revenue is recorded each time a sale is made. No entry is
made at the time of the sale to record the cost of the merchandise sold. At the end of the accounting

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period, a physical inventory is taken to determine the cost of the inventory and the cost of the merchandise
sold. Like the perpetual inventory system, a cost flow assumption must be made when identical units are
acquired at different unit costs during a period. In such cases, the fifo, lifo, or average cost method is used.

First-In, First-Out Method

To illustrate the use of the fifo method in a periodic inventory system, we assume the following data:

Jan. 1 Inventory: 200 units at $9 $ 1,800

Mar. 10 Purchase: 300 units at 10 3,000
Sept. 21 Purchase: 400 units at 11 4,400
Nov. 18 Purchase: 100 units at 12 1,200
Available for sale during year 1,000 $10,400
The physical count on December 31 shows that 300 units have not been sold. Using the fifo method, the
cost of the 700 units sold is determined as follows:

Earliest costs, Jan. 1: 200 units at $9 $1,800

Next earliest costs, Mar. 10: 300 units at 10 3,000
Next earliest costs, Sept. 21: 200 units at 11 2,200
Cost of merchandise sold: 700 $7,000
Deducting the cost of merchandise sold of $7,000 from the $10,400 of merchandise available for sale yields
$3,400 as the cost of the inventory at December 31. The $3,400 inventory is made up of the most recent
costs incurred for this item.

Last-In, First-Out Method

When the lifo method is used, the cost of merchandise sold is made up of the most recent costs. Based on
the data in the fifo example, the cost of the 700 units of inventory is determined as follows:
Most recent costs, Nov. 18: 100 units at $12 $1,200
Next most recent costs, Sept. 21: 400 units at 11 4,400
Next most recent costs, Mar. 10: 200 units at 10 2,000
Cost of merchandise sold: 700 $7,600

Deducting the cost of merchandise sold of $7,600 from the $10,400 of merchandise available for sale yields
$2,800 as the cost of the inventory at December 31. The $2,800 inventory is made up of the earliest costs
incurred for this item.

Average Cost Method

The average cost method is sometimes called the weighted average method. When this method is used,
costs are matched against revenue according to an average of the unit costs of the goods sold. The same
weighted average unit costs are used in determining the cost of the merchandise inventory at the end of the

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period. For businesses in which merchandise sales may be made up of various purchases of identical
units, the average method approximates the physical flow of goods.

The weighted average unit cost is determined by dividing the total cost of the units of each item available
for sale during the period by the related number of units of that item. Using the same cost data as in the fifo
and lifo examples, the average cost of the 1,000 units, $10.40, and the cost of the 700 units, $7,280, are
determined as follows:
Average unit cost: $10,400/1,000 units = $10.40
Cost of merchandise sold: 700 units at $10.40 = $7,280
Deducting the cost of merchandise sold of $7,280 from the $10,400 of merchandise available for sale yields
$3,120 as the cost of the inventory at December 31.

1.6. Comparing inventory costing methods

As we have illustrated, a different cost flow is assumed for each of the three alternative methods of costing
inventories. You should note that if the cost of units had remained stable, all three methods would have
yielded the same results. Since prices do change, however, the three methods will normally yield different
amounts for (1) the cost of the merchandise sold for the period, (2) the gross profit (and net income) for the
period, and (3) the ending inventory. Using the preceding examples for the periodic inventory system and
assuming that net sales were $15,000, the following partial income statements indicate the effects of each
method:
Partial Income Statements
First-In, First-Out Average Cost Last-In, First-Out
Net sales $15,000 $15,000 $15,000
Cost of merchandise sold:
Beginning inventory $ 1,800 $ 1,800 $ 1,800
Purchases 8,600 8,600 8,600
Merchandise available for sale $10,400 $10,400 $10,400
Less ending inventory 3,400 3,120 2,800
Cost of merchandise sold 7,000 7,280 7,600
Gross profit $ 8,000 $ 7,720 $ 7,400

As shown above, the fifo method yielded the lowest amount for the cost of merchandise sold and the
highest amount for gross profit (and net income). It also yielded the highest amount for the ending
inventory. On the other hand, the lifo method yielded the highest amount for the cost of merchandise sold,
the lowest amount for gross profit (and net income), and the lowest amount for ending inventory. The
average cost method yielded results that were between those of fifo and lifo.

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Fifo
during a period of inflation or
rising prices, the earlier unit
costs are lower than the more
recent unit costs. Thus, fifo will
show a larger gross profit.
the inventory must be replaced
at prices higher than indicated
by the cost of merchandise
sold.
the balance sheet will report the
ending merchandise inventory
at an amount that is about the
same as its current replacement
cost.
When the rate of inflation
reaches double digits, the larger
gross profits are often called
inventory profits or illusory
profits.
In a period of deflation or
declining prices, the effect is
just the opposite.
Uses of Fifo, Lifo and Average cost method
Lifo Average cost
during a period of inflation, the lifo method will yield It is a compromise
a higher amount of cost of merchandise sold, a between fifo and lifo.
lower amount of gross profit, and a lower amount of The effect of price
inventory at the end of the period than the other two trends is averaged in
methods. determining the cost of
the cost of the most recently acquired units is about merchandise sold and
the same as the cost of their replacement. the ending inventory.
It can more nearly matches current costs with For a series of
current revenues. purchases, the average
The ending inventory on the balance sheet may be cost will be the same,
quite different from its current replacement cost. In regardless of the
such cases, the financial statements normally direction of price trends.
include a note that states the estimated difference
between the lifo inventory and the inventory if fifo
had been used.
During periods of rising prices, it offers an income
tax savings. The income tax savings results
because lifo reports the lowest amount of net
income of the three methods.
During the double-digit inflationary period, many
businesses change from fifo to lifo for the tax
savings.
In a period of deflation or declining prices, the effect
is just the opposite.

1.7. Valuation of inventory at other than cost

Cost is the primary basis for valuing inventories. In some cases, however, inventory is valued at other than
cost. Two such cases arise when (1) the cost of replacing items in inventory is below the recorded cost and
(2) the inventory is not salable at normal sales prices. This latter case may be due to imperfections, shop
wear, style changes, or other causes.

Valuation at Lower of Cost or Market

If the cost of replacing an item in inventory is lower than the original purchase cost, the lower-of-cost-or-
market (LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the cost
to replace the merchandise on the inventory date. This market value is based on quantities normally
purchased from the usual source of supply. In businesses where inflation is the norm, market prices rarely
decline. In businesses where technology changes rapidly (e.g., microcomputers and televisions), market
declines are common. The primary advantage of the lower-of-cost-or-market method is that gross profit
(and net income) is reduced in the period in which the market decline occurred.

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In applying the lower-of-cost-or-market method, the cost and replacement cost can be determined in one of
three ways. Cost and replacement cost can be determined for (1) each item in the inventory, (2) major
classes or categories of inventory, or (3) the inventory as a whole. In practice, the cost and replacement
cost of each item are usually determined.

To illustrate, assume that there are 400 identical units of Item A in inventory, acquired at a unit cost of
$10.25 each. If at the inventory date the item would cost $10.50 to replace, the cost price of $10.25 would
be multiplied by 400 to determine the inventory value. On the other hand, if the item could be replaced at
$9.50 a unit, the replacement cost of $9.50 would be used for valuation purposes.

A method of organizing inventory data and applying the lower-of-cost-or-market method to each inventory
item is illustrated below. The amount of the market decline, $450 ($15,520 - $15,070), may be reported as
a separate item on the income statement or included in the cost of merchandise sold. Regardless, net
income will be reduced by the amount of the market decline.

Commodity Inventory Unit Cost Unit Market Total

Quantity Price Price Cost Market Lower of C or M
A 400 $10.25 $ 9.50 $ 4,100 $ 3,800 $ 3,800
B 120 22.50 24.10 2,700 2,892 2,700
C 600 8.00 7.75 4,800 4,650 4,650
D 280 14.00 14.75 3,920 4,130 3,920
Total $15,520 $15,472 $15,070

Valuation at Net Realizable Value

As you would expect, merchandise that is out of date, spoiled, or damaged or that can be sold only at
prices below cost should be written down. Such merchandise should be valued at net realizable value. Net
realizable value is the estimated selling price less any direct cost of disposal, such as sales commissions.
For example, assume that damaged merchandise costing $1,000 can be sold for only $800, and direct
selling expenses are estimated to be $150. This inventory should be valued at $650 ($800 - $150), which is
its net realizable value.

1.8. Estimating inventory costs

It may be necessary for a business to know the amount of inventory when perpetual inventory records are
not maintained and it is impractical to take a physical inventory. For example, a business that uses a
periodic inventory system may need monthly income statements, but taking a physical inventory each
month may be too costly. Moreover, when a disaster such as a fire has destroyed the inventory, the amount
of the loss must be determined. In this case, taking a physical inventory is impossible, and even if perpetual

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inventory records have been kept, the accounting records may also have been destroyed. In such cases,
the inventory cost can be estimated by using (1) the retail method or (2) the gross profit method.

Retail Method of Inventory Costing

The retail inventory method of estimating inventory cost is based on the relationship of the cost of
merchandise available for sale to the retail price of the same merchandise. To use this method, the retail
prices of all merchandise are maintained and totaled. Next, the inventory at retail is determined by
deducting sales for the period from the retail price of the goods that were available for sale during the
period. The estimated inventory cost is then computed by multiplying the inventory at retail by the ratio of
cost to selling (retail) price for the merchandise available for sale.

Cost Retail
Merchandise inventory, January 1 $19,400 $ 36,000
Purchases in January (net) 42,600 64,000
Merchandise available for sale $62,000 $100,000
$ 62,000
Ratio of cost to retail price: = 62%
$ 100,000
Sales for January (net) 70,000
Merchandise inventory, January 31, at retail $ 30,000
Merchandise inventory, January 31, at estimated cost ($30,000 x 62%) $ 18,600
One of the major advantages of the retail method is that it provides inventory figures for preparing monthly
or quarterly statements when the periodic system is used. Department stores and similar merchandisers
like to determine gross profit and operating income each month but may take a physical inventory only
once or twice a year. In addition, comparing the estimated ending inventory with the physical ending
inventory, both at retail prices, will help identify inventory shortages resulting from shoplifting and other
causes. Management can then take appropriate actions.

The retail method may also be used as an aid in taking a physical inventory. In this case, the items counted
are recorded on the inventory sheets at their retail (selling) prices instead of their cost prices. The physical
inventory at selling price is then converted to cost by applying the ratio of cost to selling (retail) price for the
merchandise available for sale.

Gross Profit Method of Estimating Inventories

The gross profit method uses the estimated gross profit for the period to estimate the inventory at the end
of the period. The gross profit is usually estimated from the actual rate for the preceding year, adjusted for
any changes made in the cost and sales prices during the current period. By using the gross profit rate, the
dollar amount of sales for a period can be divided into its two components: (1) gross profit and (2) cost of

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merchandise sold. The latter amount may then be deducted from the cost of merchandise available for sale
to yield the estimated cost of the inventory. Below, illustrates the gross profit method for estimating a
company’s inventory on January 31. In this example, the inventory on January 1 is assumed to be $57,000,
the net purchases during the month are $180,000, and the net sales during the month are $250,000. In
addition, the historical gross profit was 30% of net sales.

The gross profit method is useful for estimating inventories for monthly or quarterly financial statements in a
periodic inventory system. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.

Merchandise inventory, January 1 $ 57,000

Purchases in January (net) 180,000
Merchandise available for sale $237,000
Sales in January (net) $250,000
Less estimated gross profit ($250,000 x 30%) 75,000
Estimated cost of merchandise sold 175,000
Estimated merchandise inventory, January 31 $ 62,000

1.9. Presentation of merchandise inventory on the balance sheet

Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following
receivables. Both the method of determining the cost of the inventory (fifo, lifo, or average) and the method
of valuing the inventory (cost or the lower of cost or market) should be shown. It is not unusual for large
businesses with varied activities to use different costing methods for different segments of their inventories.
The details may be disclosed in parentheses on the balance sheet or in a footnote to the financial
statements.

A company may change its inventory costing methods for a valid reason. In such cases, the effect of the
change and the reason for the change should be disclosed in the financial statements for the period in
which the change occurred.

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 Worksheet for chapter 1
1. Marcelle’s Boutiques, which is located in Iowa City, Iowa, has identified the following items for possible
inclusion in its December 31, 2005 year-end inventory.
a. Merchandise Marcelle’s shipped to a customer FOB shipping point was picked up by the freight
company on December 26, 2005, but had still not arrived at its destination as of December 31,
2005.
b. Marcelle’s has segregated $6,570 of merchandise ordered by one of its customers for shipment on
January 3, 2006.
c. Marcelle’s has sent $78,000 of merchandise to various retailers on a consignment basis.
d. Marcelle’s has $18,750 of merchandise on hand, which was sold to customers earlier in the year,
but which has been returned by customers to Marcelle’s for various warranty repairs.
e. On December 31, 2005, Marcelle’s received $17,050 of merchandise that had been returned by
customers because the wrong merchandise had been shipped. The replacement order is to be
shipped overnight on January 3, 2006.
f. On December 21, 2005, Marcelle’s ordered $21,000 of merchandise, FOB Iowa City. The
merchandise was shipped from the supplier on December 28, 2005, but had not been received by
December 31, 2005.
g. On December 27, 2005, Marcelle’s ordered $15,750 of merchandise from a supplier in Davenport.
The merchandise was shipped FOB Davenport on December 30, 2005, but had not been received
by December 31, 2005.
 Indicate which items should be included (I) and which should be excluded (E) from the inventory.
2. Crazy Rapids Co. sells canoes, kayaks, whitewater rafts, and other boating supplies. During the taking
of its physical inventory on December 31, 2006, Crazy Rapids incorrectly counted its inventory as
$117,800 instead of the correct amount of $119,750.
a. State the effect of the error on the December 31, 2006 balance sheet of Crazy Rapids.
b. State the effect of the error on the income statement of Crazy Rapids for the year ended December
31, 2006.

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3. Beginning inventory, purchases, and sales data for portable CD players are as follows:
April 1 Inventory 35 units at $50
5 Sale 26 units
11 Purchase 15 units at $53
21 Sale 12 units
28 Sale 4 units
30 Purchase 7 units at $54

The business maintains a perpetual inventory system, costing by the first-in, first-out method. Determine
the cost of the merchandise sold for each sale and the inventory balance after each sale.

Assume that the business maintains a perpetual inventory system, costing by the last-in, first-out method.
Determine the cost of merchandise sold for each sale and the inventory balance after each sale.

4. The following units of a particular item were available for sale during the year:
Beginning inventory 20 units at $45
Sale 15 units at $80
First purchase 31 units at $47
Sale 27 units at $80
Second purchase 40 units at $50
Sale 35 units at $80

The firm uses the perpetual inventory system, and there are 14 units of the item on hand at the end of the
year. What is the total cost of the ending inventory according to (a) fifo, (b) lifo?

5. On the basis of the following data, determine the value of the inventory at the lower of cost or market.

Commodity Inventory Quantity Unit Cost Price Unit Market Price

M76 8 $150 $160
T53 20 75 70
A19 10 275 260
J81 15 50 40
K10 25 101 105

6. On the basis of the following data, estimate the cost of the merchandise inventory at June 30 by the
retail method:

Cost Retail
June 1 Merchandise inventory $160,000 $ 180,000
June 1–30 Purchases (net) 680,000 1,020,000
June 1–30 Sales (net) 875,000

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7. The merchandise inventory was destroyed by fire on May 17. The following data were obtained from
the accounting records:

Jan. 1 Merchandise inventory $ 180,000

Jan. 1–May 17 Purchases (net) 750,000
Sales (net) 1,250,000
Estimated gross profit rate 35%

a. Estimate the cost of the merchandise destroyed.

b. Briefly describe the situations in which the gross profit method is useful.

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