ch06 Inventory

6-1
6
REPORTING AND
ANALYZING INVENTORY
6-2 Financial Accounting, Sixth Edition

Study Objectives
1. Describe the steps in determining inventory quantities.
2. Explain the basis of accounting for inventories and apply the

inventory cost flow methods under a periodic inventory system.
3. Explain the financial statement and tax effects of each of the

inventory cost flow assumptions.
4. Explain the lower-of-cost-or-market basis of accounting for

inventories.
5. Compute and interpret the inventory turnover ratio.
6. Describe the LIFO reserve and explain its importance for

comparing results of different companies.
6-3
Reporting and Analyzing Inventory
Determining
Classifying Inventory Analysis of
Inventory
Inventory Costing Inventory
Quantities
Merchandising Taking a Specific Inventory

Manufacturing physical identification turnover ratio
inventory Cost flow LIFO reserve
Just-in-time
Determining assumptions
ownership of Financial
goods statement and
tax effects
Consistent use
Lower-of-cost-
or-market
6-4
Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
 Merchandise  Raw Materials

Inventory
 Work in Process
 Finished Goods
Regardless of the classification, companies report all inventories

under Current Assets on the balance sheet.
6-5
6-6
Determining Inventory Quantities
Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand
2. Determine the cost of goods sold for the period.
6-7 SO 1 Describe the steps in determining inventory quantities.

Taking a Physical Inventory

Involves counting, weighing, or measuring each kind
of inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.

6-9
Determining Ownership of Goods

Goods in Transit
 Purchased goods not yet received.
 Sold goods not yet delivered.
Goods in transit should be included in the inventory of the

company that has legal title to the goods. Legal title is
determined by the terms of sale.

Goods in Transit Illustration 6-1

Terms of sale
Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.
Ownership of the goods

remains with the seller until
the goods reach the buyer.
6-11
Review Question
Goods in transit should be included in the inventory of
the buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.

Determining Ownership of Goods

Consigned Goods
Goods held for sale by one party although ownership
of the goods is retained by another party.

$
6-14
Inventory Costing
Unit costs can be applied to quantities on hand

using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Cost Flow
Last-in, first-out (LIFO) Assumptions
Average-cost
6-15 SO 2 Explain the basis of accounting for inventories and apply the
Inventory Costing
Illustration: Assume that Crivitz TV Company purchases

three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200
each. These facts are summarized below.
Illustration 6-2
Inventory Costing
“Specific Identification”
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Illustration 6-3
Inventory Costing
“Specific Identification”
Actual physical flow costing method in which items still
in inventory are specifically costed to arrive at the total
cost of the ending inventory.
Practice is relatively rare.
Most companies make assumptions (Cost Flow

Assumptions) about which units were sold.
Inventory Costing
Cost Flow
Assumption
does not need to equal
Physical Movement of
Goods
Illustration 6-11
Use of cost flow methods
in major U.S. companies
Inventory Cost Flow Assumptions
Illustration: Data for Houston Electronics’ Astro
condensers.
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
“First-In-First-Out (FIFO)”
 Earliest goods purchased are first to be sold.
 Often parallels actual physical flow of

merchandise.
 Generally good business practice to sell oldest

units first.
Illustration 6-5
6-22
SO 2
Illustration 6-5
“Last-In-First-Out (LIFO)”
 Latest goods purchased are first to be sold.
 Seldom coincides with actual physical flow of

merchandise.
 Exceptions include goods stored in piles, such as

coal or hay.
Illustration 6-7
6-25
Illustration 6-7
“Average-Cost”
 Allocates cost of goods available for sale on the
basis of weighted-average unit cost incurred.
 Assumes goods are similar in nature.
 Applies weighted-average unit cost to the units

on hand to determine cost of the ending
inventory.
“Average-Cost”
Illustration 6-10
“Average-Cost”
Illustration 6-10
Financial Statement and Tax Effects
Comparative Financial Statement Summary

FIFO Average LIFO
Sales $9,000 $9,000 $9,000
Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense 330 330 330
Income before taxes 2,470 2,070 1,670
Income tax expense 140 120 110
Net income $2,330 $1,950 $1,560
Inventory balance $5,800 $5,400 $5,000
6-30 LO 3 Explain the financial statement and tax effects of each

of the inventory cost flow assumptions.
In Period of Rising Prices, FIFO Reports:

FIFO Average LIFO
Sales $9,000 $9,000 $9,000
Lowest Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Highest Net income $2,330 $1,950 $1,560

In Period of Rising Prices, LIFO Reports:

FIFO Average LIFO
Sales $9,000 $9,000 $9,000
Highest Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Lowest Net income $2,330 $1,950 $1,560

Review Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

Review Question
In a period of inflation, the cost flow method that
results in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

6-35
Inventory Costing
Using Cost Flow Methods Consistently

 Method should be used consistently, enhances
comparability.
 Although consistency is preferred, a company may
change its inventory costing method.
Illustration 6-14
Disclosure of change in
cost flow method

Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
 Companies can “write down” the inventory to its

market value in the period in which the price decline
occurs.
 Market value = Replacement Cost
 Example of conservatism.
6-37 SO 4 Explain the lower-of-cost-or-market

basis of accounting for inventories.
Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as
indicated.
Illustration 6-15
6-38 SO 4 Explain the lower-of-cost-or-market

basis of accounting for inventories.
Analysis of Inventory
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying

costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stockouts and

lost sales.
6-39 SO 5 Compute and interpret the inventory turnover ratio.

Inventory Turnover Ratio

Illustration 6-16

Illustration: Data available for Wal-Mart.
Illustration 6-16

6-42
Analysts’ Adjustments for LIFO Reserve

Companies using LIFO are required to report the amount that
inventory would increase (or occasionally decrease) if the
company had instead been using FIFO. This amount is
referred to as the LIFO reserve.
Illustration 6-17
6-43 SO 6 Describe the LIFO reserve and explain its importance

for comparing results of different companies.
Analysts’ Adjustments for LIFO Reserve

The LIFO reserve can have a significant effect on ratios
analysts commonly use.
Illustration 6-19
6-44 SO 6 Describe the LIFO reserve and explain its importance

for comparing results of different companies.
Perpetual
appendix 6A Inventory
System
Illustration: Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods Sold

and Ending Inventory under FIFO, LIFO, and Average cost.
6-45 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
System
“First-In-First-Out (FIFO)” Illustration 6A-2
Cost of Goods
Ending Inventory
Sold
6-46
SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
System
“Last-In-First-Out (LIFO)” Illustration 6A-3
Cost of Goods
Ending Inventory
Sold
6-47
SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
System
“Average-Cost”
Illustration 6A-4
Cost of Goods Ending Inventory

Sold
6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Inventory
appendix 6B Errors
Inventory Errors
Common Cause:
 Failure to count or price inventory correctly.
 Not properly recognizing the transfer of legal title to

goods in transit.
 Errors affect both the income statement and

balance sheet.
6-49 SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory
appendix 6B Errors
Income Statement Effects

Inventory errors affect the computation of cost of goods sold
and net income.
Illustration 6-B1
Illustration 6-B2

Inventory
appendix 6B Errors
Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income 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 other.
 Ending inventory depends entirely on the accuracy of
taking and costing the inventory.

Inventory
appendix 6B Errors
2011 2012
Illustration 6-B3
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000
Combined income for ($3,000) $3,000

2-year period is correct. Net Income Net Income
understated overstated

Inventory
appendix 6B Errors
Review Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.

Inventory
appendix 6B Errors
Balance Sheet Effects

Effect of inventory errors on the balance sheet is
determined by using the basic accounting equation:
Illustration 6-B1
Illustration 6-B4

Key Points
 The requirements for accounting for and reporting
inventories are more principles-based under IFRS. That is,
GAAP provides more detailed guidelines in inventory
accounting.
 The definitions for inventory are essentially similar under

IFRS and GAAP. Both define inventory as assets held-for-
sale in the ordinary course of business, in the process of
production for sale (work in process), or to be consumed in
the production of goods or services (e.g., raw materials).
6-55
Key Points
 Who owns the goods—goods in transit or consigned
goods—as well as the costs to include in inventory, are
accounted for the same under IFRS and GAAP.
 Both GAAP and IFRS permit specific identification where

appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in
which specific identification must be used.
6-56
Key Points
 A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO
for inventory valuation. IFRS prohibits its use. FIFO and
average-cost are the only two acceptable cost flow
assumptions permitted under IFRS.
 IFRS requires companies to use the same cost flow

assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.
6-57
Key Points
 In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
estimated selling expenses. In other words, net realizable
value is the best estimate of the net amounts that
inventories are expected to realize. GAAP, on the other hand,
defines market as essentially replacement cost.
6-58
Key Points
 Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new value becomes its cost
basis. As a result, the inventory may not be written back up
to its original cost in a subsequent period. Under IFRS, the
write-down may be reversed in a subsequent period up to
the amount of the previous write-down. Both the write-down
and any subsequent reversal should be reported on the
income statement as an expense. An item-by-item approach
is generally followed under IFRS.
6-59
Key Points
 Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.
 Similar to GAAP, certain agricultural products and mineral

products can be reported at net realizable value using IFRS.
6-60
Looking into the Future
One convergence issue relates to the use of the LIFO cost flow
assumption. IFRS specifically prohibits its use. Conversely, the
LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. With a new conceptual
framework being developed, it is highly probable that the use of
the concept of conservatism will be eliminated. Similarly, the
concept of “prudence” in the IASB literature will also be
eliminated. This may ultimately have implications for the
application of the lower-of-cost-or-net realizable value.
6-61
Which of the following should not be included in the
inventory of a company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB

shipping point.
d) None of the above.
6-62
Which method of inventory costing is prohibited under
IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-63
Specific identification:
a) must be used under IFRS if the inventory items are not

interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most

conservative net income.
6-64
Copyright
“Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.”
6-65

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6-1

6-2 Financial Accounting, Sixth Edition

2. Explain the basis of accounting for inventories and apply the

3. Explain the financial statement and tax effects of each of the

4. Explain the lower-of-cost-or-market basis of accounting for

5. Compute and interpret the inventory turnover ratio.

6. Describe the LIFO reserve and explain its importance for

Merchandising Taking a Specific Inventory

 Merchandise  Raw Materials

Regardless of the classification, companies report all inventories

Physical Inventory taken for two reasons:

6-7 SO 1 Describe the steps in determining inventory quantities.

Taking a Physical Inventory

6-8 SO 1 Describe the steps in determining inventory quantities.

Determining Ownership of Goods

Goods in transit should be included in the inventory of the

6-10 SO 1 Describe the steps in determining inventory quantities.

Goods in Transit Illustration 6-1

Ownership of the goods

Ownership of the goods

6-12 SO 1 Describe the steps in determining inventory quantities.

Determining Ownership of Goods

6-13 SO 1 Describe the steps in determining inventory quantities.

Unit costs can be applied to quantities on hand

Illustration: Assume that Crivitz TV Company purchases

Practice is relatively rare.

Most companies make assumptions (Cost Flow

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

 Often parallels actual physical flow of

 Generally good business practice to sell oldest

 Seldom coincides with actual physical flow of

 Exceptions include goods stored in piles, such as

 Assumes goods are similar in nature.

 Applies weighted-average unit cost to the units

Comparative Financial Statement Summary

Inventory balance $5,800 $5,400 $5,000

6-30 LO 3 Explain the financial statement and tax effects of each

In Period of Rising Prices, FIFO Reports:

Inventory balance $5,800 $5,400 $5,000

6-31 LO 3 Explain the financial statement and tax effects of each

In Period of Rising Prices, LIFO Reports:

Inventory balance $5,800 $5,400 $5,000

6-32 LO 3 Explain the financial statement and tax effects of each

6-33 LO 3 Explain the financial statement and tax effects of each

6-34 LO 3 Explain the financial statement and tax effects of each

Using Cost Flow Methods Consistently

6-36 LO 3 Explain the financial statement and tax effects of each

 Companies can “write down” the inventory to its

 Market value = Replacement Cost

6-37 SO 4 Explain the lower-of-cost-or-market

6-38 SO 4 Explain the lower-of-cost-or-market

Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying

2. Low Inventory Levels – may lead to stockouts and

6-39 SO 5 Compute and interpret the inventory turnover ratio.

Inventory Turnover Ratio

6-40 SO 5 Compute and interpret the inventory turnover ratio.

Illustration: Data available for Wal-Mart.