Chapter 16 || Accounting

Inventories in Action

Learning Objectives:
1. Describe the steps in determining inventory quantities.
2. Explain the accounting for inventories and apply the inventory cost flow
methods.
3. Explain the financial effects of the inventory cost flow assumptions.

4. Explain the lower-of-cost-or-net realizable value basis of accounting for

inventories.
5. Indicate the effects of inventory errors on the financial statements.
6. Compute and interpret the inventory turnover ratio.
Classification of Inventory [Reported under Current Assets section of SOFP]

Merchandising Co. Manufacturing Co.

The goods (unprocessed material) that is used in
1) Inventory 1) Raw Material production process to covert into final product.

That portion of manufactured inventory that has

2) Work in Process (WIP)
been placed into the production process but is not
yet complete (Partially completed)

3) Finished Goods Manufactured items, completed and ready for sale

4) Stores & Spares Consumables and plant upkeeps

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

WHY INVENTORY IS IMPORTANT
Risks in carrying inventory
▪ Ensures smooth and uninterrupted
production flow / operations Carrying inventory has its costs; an optimum
level (varies from business to business) is
▪ Eliminates the risk of stock outs; thus ensures crucial.
meeting customer order timely, in turns helps
in customer retention Too little inventory has risks of:
▪ Stock out, disruption in production
▪ To take advantage of price discounts / ▪ Lost sales in turns income loss
economy in purchasing ▪ Losing customer confidence and hence
relation issues

Too high level of inventory has risk of:

Inventory Mgt. System
Provides complete inventory solution and helps in
keeping the carrying cost of inventory at its
minimum level.
▪ Inefficient cash management- cash tied up
in inventory
▪ Obsolescence – cost of write offs
▪ Holding / storage cost including wastage,
theft, damage, pilferage

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

 Determining Inventory – Quantity

▪ Involves counting, weighing, or measuring each kind of inventory on

Physical Inventory Count
hand
/ Stock-take
▪ Done at the end of accounting period

Determining Ownership of Goods 2. CONSIGNED GOODS

1. GOODS IN TRANSIT
▪ Purchased, not yet received
▪ To hold the goods of other Co. and sell on
their behalf – the ownership of goods is
retained with the Co.
✓ Goods in transit should be included in the inventory of the
company that has legal title to the goods.

▪ Sold not yet delivered ✓ Legal title is determined by the terms of sale;
FOB Shipping Point OR FOB Destination

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

ABC Co. completed its inventory count & arrived at a value of $200,000. From the
following information, calculate the reported cost of inventory.

1. Included in the inventory goods held on consignment for XYZ Co., costing $15,000.

2. Did not include in the count purchased goods of $10,000, which were in transit (terms:
FOB shipping point).

3. Did not include in the count inventory that had been sold with a cost of $12,000, which
was in transit (terms: FOB shipping point).

Inventory should be $195,000

($200,000 - $15,000 + $10,000)

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Determining Inventory – Value
Inventory is accounted for at cost.
▪ Cost includes all expenses necessary to acquire goods and place them in a condition ready for sale.
▪ Total Cost of Inventory = Unit costs X Quantities

Costing Methods
Actual physical flow costing method in which items still in
➢ Specific identification
inventory are specifically cost to arrive at the total cost of the
ending inv.

➢ First-in, first-out (FIFO)

Cost Flow Cost flow does not need be consistent with
➢ Average-cost (AVCO)
Assumptions the physical movement of the goods
➢ Last-in, First-out (LIFO)

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

 Vintage Used Cars uses the specific identification method of costing inventory. During
March, Mr. Vintage purchased three cars for $6,000, $7,500, and $9,750, respectively.
During March, two cars are sold for $9,000 each. Mr. Vintage determines that at
March 31, the $9,750 car is still on hand. What is Vintage’s gross profit for March?

Solution
Car 1 $6,000 Sales Revenue $9,000 x 2 = $18,000
Car 2 7,500
Car 3 9,750 In hand Less: Cost of Cars Sold $6,000 + $7,500 = $13,500
COGAS $23,250 (Ending Inv.)
Gross Profit $4,500

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Determining Value of Inventory

FIFO Method AVCO Method

▪ Costs of earliest goods purchased ▪ Allocates cost of goods available
are first to be recognized in for sale on basis of weighted-
determining COGS. average unit cost incurred.

▪ Follows the actual physical flow ▪ Applies weighted-average unit

of merchandise. cost to units on hand to
determine cost of ending
▪ Companies determine cost of inventory.
ending inventory by taking unit
cost of most recent purchase and
working backward until all units
of inventory have been costed.

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

 Determining Value of Inventory | FIFO Method

Next Generation Mobiles Limited

Step 1: Ending Inventory

Units in Ending Inventory: 45

Nov. 27 40 units @$130 $5,200
Aug. 24 5 units @ $120 600
45 units $ 5,800

Step 2: COGS
COGAS
COGS = COGAS – Ending Inventory

COGS = $12,000 – $5,800 = $6,200

Alternative Calculation
Step 1: Calculate COGS using FIFO
Step 2: Calculate Ending Inventory | (COGAS – COGS )
Prepared by Saira Rizwan for LUMS undergrad course ACCT-100
 Perpetual Inventory System | Inventory Costing Methods
Computation of COGS and Ending Inventory under FIFO

FIRST-IN; FIRST-OUT METHOD

Next Generation Mobiles Limited

Ending
Cost of
Inventory
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 Determining Value of Inventory | AVCO Method
Step 1: Calculate Weighted Avg. Cost
Next Generation Mobiles Limited
COGAS $12,000
Total units available for sale 100
Weighted Avg. Unit Cost $120

Step 2: Calculate Ending Inventory

Units in Ending x Weighted

Inventory Avg. Unit Cost
COGAS
45 x $120 = $5,400

Step 3: Calculate COGS

COGAS – Ending Inventory
$12,000 – 5,400= $6,600
Prepared by Saira Rizwan for LUMS undergrad course ACCT-100
Perpetual Inventory System | Inventory Costing Methods
Computation of COGS and Ending Inventory under AVCO

Next Generation Mobiles Limited

WEIGHTED-AVERAGE COST METHOD

Cost of Goods Sold Ending Inventory

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Costing Methods | Comparative Effects
In inflationary times: Next Generation Mobiles Limited
Condensed Income Statement
▪ Under FIFO method, cost of
ending inventory will be
higher (~current prices); hence
COGS will be lower, and Net
Profit will be higher. This will
result in higher Income tax.

▪ Under AVCO method, the

costs of ending inventory will
be understated in terms of
current cost; hence COGS will
be higher, and Net Profit will *We assumes Next Generation Mobiles is a Corporate which by company law is subject
to pay income tax.
lower. This will result in lower
Method should be used consistently, enhances comparability.
Income tax.
Prepared by Saira Rizwan for LUMS undergrad course ACCT-100
Effects of Errors in Reporting Inventory On Income Statement

CONCLUSION

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Rizwan for LUMS
undergrad course
ACCT-100
Effects of Errors in Reporting Inventory On Income Statement
End.

CONCLUSION

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Income Statement Effects Inventory errors affect the Income Statement 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
€3,000
Net income other
overstated

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Effects of Errors in End. Inventory On Statement of Financial Position

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Lower of Cost OR Net Realizable Value (NRV)
▪ When the value of inventory is lower than its cost
companies must “write down” the inventory to its net realizable value.

▪ Net Realizable Value (NRV): Amount that a company expects to realize (receive from the
sale of inventory).

Illustration: Compute the total value of inventory

for Sunrise Packages Ltd.'s based on the
following:

Inv. Categories Cost NRV LC /NRV

A $18,000 $17,200 $17,200
B 14,000 14,600 14,000
C 21,000 20,500 20,500

Total Valuation $51,700

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Presentation of Inventory in Financial Statements

Statement of Financial Position - Inventory classified as current asset.

Income Statement - Cost of goods sold is subtracted from sales.

There also should be disclosure of the:

1) major inventory classifications,

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

3) costing method (specific identification, FIFO, or average-cost).

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 Inventory Management | Analysis
1) Inventory turnover measures the number of times on average the inventory is sold during the period.

Cost of Goods Sold The lower the

Inventory Turnover =
Average Inventory inventory turnover;
the beneficial it is for
the entity.
True / False

2) Days in inventory measures the average number of days inventory is held.

Days in Year (365) The lower the number

Inventory days =
Inventory Turnover of inventory days; the
beneficial it is for the
entity.
True / False

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Inventory Management | Analysis
This information relates to Xerox Corporation:
20X9 20X0 Required: (i) Calculate:
Beginning inventory $ 200,000 $ 300,000 a) inventory turnover,
Ending inventory 300,000 380,000 b) Inventory Days, and
Cost of goods sold 1,150,000 1,330,000 c) Gross Profit Margin for both years.
Sales 1,600,000 1,900,000 (ii) Comment on YoY trend

Inventory Days in Gross

turnover Inventory Profit Rate

20X9 $1,150 _____ = 4.6x 365 = ~80 $1,600 – $1,150 x 100 = 28%
($200 + $300)  2 4.6 $1,600

20X0 $1,330 ______ = 3.9x 365 = ~94 $1,900 – $1,330 x 100 = 30%
($300 + $380)  2 3.9 $1,900

Prepared by Saira Rizwan for LUMS undergrad course ACCT-100

Thank You for your attention!