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Chapter 8 and 9

INVENTORIES

© 2013 The McGraw-Hill Companies, Inc.

Recording and Measuring Inventory

Types of Inventory

Merchandise Manufacturing
Inventory Inventory
Goods acquired for •Raw Materials
resale •work-in-progress
•Finished Goods
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Manufacturing Inventories
Raw Work in Finished
Materials Progress Goods

  $XX
 $XX

Direct
Labor

  Cost of Goods Sold

$XX
Manufacturing
Overhead

   Raw materials purchased

 Direct labor incurred
 Manufacturing overhead incurred
 Raw materials used
 Direct labor applied
 Manufacturing overhead applied
 Work in progress transferred to finished goods
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 Finished goods sold

Inventory Systems
Two accounting systems are used to record
transactions involving inventory:

Perpetual Periodic Inventory

Inventory System System
The inventory
account is The inventory
continuously account is
updated as adjusted at the end
purchases and of a reporting
sales are made. cycle.
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Comparison of Inventory Systems

Transaction or
Periodic Inventory Perpetual Inventory
Event

Routine purchases of Costs debited to Costs debited to

various inventory items purchases account inventory account

Debit Cost of goods

No accounting entries
Sale of inventory sold and credit
made to inventory
inventory

Physical count to
End-of-period No separate
determine ending
accounting entries and determination of cost of
inventory and cost of
related activities goods sold necessary
goods sold

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Perpetual Inventory System

Lothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2013
Inventory 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account

Returns of inventory are credited to the inventory

account.
Discounts on inventory purchases can be recorded
using the gross or net method.

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Perpetual Inventory System

During 2013, LWBC sold, on account, inventory with a retail
price of $820,000 and a cost basis of $540,000, to customers.
2013
Inventory 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account.

2013
Accounts receivable 820,000
Sales revenue 820,000
Record sales on account.

Cost of goods sold 540,000

Inventory 540,000
Record cost of goods sold.

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Periodic Inventory System

The periodic inventory system is not designed to track
either the quantity or cost of merchandise inventory. Cost
of goods sold is calculated, using the schedule below, after
the physical inventory count at the end of the period.

Beginning Inventory
+ Net Purchases
Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold

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Periodic Inventory System

Lothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2013
Purchases 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account

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Periodic Inventory System

During 2013, LWBC sold, on account, inventory with a retail
price of $820,000 to customers, and a cost basis of $540,000.

2013
Accounts receivable 820,000
Sales revenue 820,000
Record sales on account.

No entry is made to record Cost of Goods Sold. A physical count

of Ending Inventory shows a balance of $180,000. Let’s
calculate Cost of Goods Sold at the end of 2013.

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Periodic Inventory System

Calculation of Cost of Goods Sold
Beginning inventory $ 120,000
Plus: Purchases 600,000
Cost of goods available for sale 720,000
Less: Ending inventory (180,000)
Cost of goods sold $ 540,000

We need the following adjusting entry to record cost of good sold.

December 31, 2013
Cost of goods sold 540,000
Inventory (ending) 180,000
Inventory (beginning) 120,000
Purchases 600,000
To adjust inventory, close purchases, and record cost of goods sold.

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Comparison of Inventory Systems

Transaction or
Periodic Inventory Perpetual Inventory
Event

Routine purchases of Costs debited to Costs debited to

various inventory items purchases account inventory account

Debit Cost of goods

No accounting entries
Sale of inventory sold and credit
made to inventory
inventory

Physical count to
End-of-period No separate
determine ending
accounting entries and determination of cost of
inventory and cost of
related activities goods sold necessary
goods sold

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What is Included in Inventory?

General Rule
All goods owned by the company on the inventory
date, regardless of their location.

Goods in Transit Goods on

Consignment

Depends on FOB
shipping terms.

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Expenditures Included in Inventory

Purchase
Invoice Price Returns and
Allowances

Freight-in on Purchase
Purchases Discounts

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Purchase Returns
On November 8, 2013, LWBC returns merchandise that had a cost
to LWBC of $2,000, and a cost basis to the seller of 1,600.

Periodic Inventory Method Perpetual Inventory Method

November 8, 2013
Accounts payable 2,000 Accounts payable 2,000
Purchase returns and allowances 2,000 Inventory 2,000

Returns of inventory are credited to the Purchase Returns

and Allowances account when using the periodic
inventory method.
The returns are credited to Inventory using the
perpetual inventory method.
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Purchase Discounts (perpetual)

Gross Method Net Method
October 5, 2013
Inventory 20,000 Inventory 19,600
Accounts payable 20,000 Accounts payable 19,600

October 14, 2013

Accounts payable 14,000 Accounts payable 13,720
Inventory 280 Cash 13,720
Cash 13,720

November 4, 2013
Accounts payable 6,000 Accounts payable 5,880
Cash 6,000 Interest expense 120
Cash 6,000

Discount terms are $20,000

2/10, n/30. Partial payment not x 0.02
$14,000 made within the $ 400
x 0.02 discount period -120
$ 280 $ 280
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Inventory Cost Flow Assumptions

• Specific identification
• Average cost
• First-in, first-out (FIFO)

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Inventory Management
The higher the ratio, the higher is
Gross profit
Gross profit ratio = the markup a company is able to
Net sales
achieve on its products.

Cost of goods sold

Inventory turnover ratio =
Average inventory

Designed to evaluate a company’s (Beginning inventory + Ending inventory

effectiveness in managing its 2
investment in inventory

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Reporting -- Lower of Cost or Market

Inventories are valued at the lower-

of-cost-or market.

LCM is a departure from historical cost. The method

causes losses to be recognized in the period the value
of inventory declines below its cost rather than in the
period that the goods ultimately are sold.

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Determining Market Value

 IAS No. 2 defines

“market value” as the
net realizable value
(NRV). + Estimated selling price
− Cost of Completion
 NRV is the estimated − Cost to sell
selling price in the
ordinary course of = Net Realizable Value /
business less Market Value
estimated cost of
completion and
disposal (cost to sell).
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Lower of Cost or Market

• An item in inventory has a historical cost
of $20 per unit. At year-end we gather the
following per unit information:
• selling price = $30
• cost to complete and dispose = $4

• How would we value this item in the

statement of financial position?

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Applying Lower of Cost or Market

Lower of cost or market can be applied 2
different ways.

1. Apply
2. Apply1)
LCM Individual
LCMto each Items
to logical
individual
inventory
item in
categories.
2) Group of similarinventory.
or related inventory items

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Adjusting Cost to Market

Record the Loss as part of Cost of Goods Sold or
by using an allowance account.
.

Cost of goods sold XX

Inventory XX

Cost of goods sold XX

Inventory allowance XX

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Reversal of Write-Downs

• Re-assess NRV at the end of every

After Write subsequent period
Down

• If current carrying value is lower

than the revised NRV
Write-Up • Write-up allowed up to the lower of
Allowed the revised NRV and original cost

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Inventory Estimation Techniques

 Estimate instead of taking physical inventory
1. Less costly
2. Less time consuming
 Two popular methods of estimating ending
inventory are the . . .
1. Gross Profit Method
2. Retail Inventory Method

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Gross Profit Method

Estimating inventory Auditors are testing the
and COGS for interim overall reasonableness
reports. of client inventories.

Useful
when . . .

Determining the cost of

Preparing budgets and
inventory lost,
forecasts.
destroyed, or stolen.

NOTE: The Gross Profit Method is not acceptable

for use in annual financial statements.
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Gross Profit Method

This method assumes that the historical gross
margin ratio is reasonably constant in the short-run.

Beginning Inventory (from accounting records)

Plus: Net purchases (from accounting records)
Goods available for sale (calculated)
Less: Cost of goods sold (estimated)
Ending inventory (estimated)

Estimate the Historical Gross Profit Ratio

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Gross Profit Method

Matrix, Inc. uses the gross profit method to estimate
end of month inventory. At the end of May, the
controller has the following data:

1. Net sales for May = $1,213,000

2. Net purchases for May = $728,300
3. Inventory at May 1 = $237,400
4. Estimated gross profit ratio = 43% of sales

Estimate Inventory at May 31.

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Gross Profit Method

Beginning Inventory $ 237,400
Plus: Net Purchases 728,300
= Goods Available for Sale 965,700
Less: Estimated COGS* (691,410)
= Estimated Ending Inventory $ 274,290

* COGS = Sales x (1 - GP%) = $ 1,213,000 x ( 1 - 43% )

= $ 691,410

NOTE: The key to successfully applying this

method is a reliable Gross Profit Ratio.

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The Retail Inventory Method

• This method was developed for retail
operations like department stores.
• Uses both the retail value and cost of
items for sale to calculate a cost to retail
percentage.

Objective: Convert ending inventory at

retail to ending inventory at cost.

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